Is the "butterfly effect" about to play out in the forex market? 41% hedging sets the stage for an accelerated USD depreciation, with $230 billion in sell orders ready to be unleashed

The key logic behind the renewed wave of “devaluation trades” around the US dollar is not the Federal Reserve’s rate cut expectations, but rather the weakening of two traditional pillars supporting the dollar: On one hand, the narrowing interest rate spread between the US and other economies has driven down the cost of FX hedging; on the other hand, the rapid expansion of the fiscal deficit is causing term premiums on US Treasuries to keep rising, actions by the US Treasury to suppress long-end Treasury yields to lower baseline funding costs, and concerns over the independence of monetary policy—all of which are undermining the dollar’s credibility as a safe haven asset in times of crisis. The dollar has already fallen about 2% this quarter, and its trend is increasingly detached from both nominal and real yields, indicating that market pricing has shifted focus from the “interest rate differential advantage” to “policy and fiscal credibility.”

According to observations from the Zhitong Finance APP, what’s truly worth watching recently is the abnormally low FX hedge ratio among global institutional investors. As of June 30, institutional investors in six markets—including Japan, Canada, and Taiwan—hedged only 41% of foreign currency transaction exposure, the lowest level since at least 2015. Based on their $4.6 trillion in foreign currency assets, a mere 5-percentage-point increase in hedging could trigger a massive $230 billion dollar selling transaction.

This does not mean that investors will immediately sell $230 billion worth of US equities or Treasuries, but rather, they may choose to retain their US assets while selling US dollars and buying their local currencies via FX forwards, swaps, or other derivatives. Thus, this represents a potential source of selling pressure on the dollar rather than an actual or inevitable spot sell-off. Nonetheless, these data do introduce an asymmetric risk: the current low hedge ratio isn’t directly depressing the dollar, but should the dollar stop appreciating in a risk-off environment, pension and insurance institutions might simultaneously offload US dollar forward contracts, creating a negative feedback loop of “dollar decline—hedging increases—further dollar weakness.”

This does not mean global investors must sell US equities or Treasuries. Institutions can easily continue holding US assets, while selling US dollars via derivatives for currency risk hedging. Therefore, the demand for US assets and the dollar’s trend may further diverge. Japan could be the primary trigger for another round of re-hedging, and the euro might become the main beneficiary currency. However, from a long-term investment perspective, the relative policy trajectory of the Federal Reserve versus other central banks remains the dominant variable for dollar pricing, and re-hedging is more likely to amplify the existing downtrend than to independently spark a new dollar bear market.

Low Hedge Ratios Lay the Groundwork for Potential Selling, US Dollar Naked Positions Reach Extreme Historic Levels

Reviewing disclosure filings from pension funds and insurance companies globally reveals a striking point: Some of the largest holders of US assets provide almost no hedge-level protection against US dollar weakness; a sudden shift in market sentiment could see the dollar index face significantly heightened downside risk.

According to estimates based on data from six relevant markets, as of June 30, investors in Japan, Canada, and Taiwan only hedged 41% of their foreign currency exposure—the lowest since at least 2015. While this is not the full picture, it provides a glimpse: Last year’s short-lived hedging frenzy—sparked by Donald Trump’s aggressive global tariff policies and the resultant dollar devaluation risk—has dissipated as the dollar has stabilized.

With declining hedge ratios, investors are returning to strategies that worked for much of the past decade. During heightened volatility, the dollar index has typically strengthened, or at least held firm, thus providing a buffer when converting US stocks and bonds back into investors’ home currencies. Meanwhile, persistently high hedging costs have left investors with little incentive to pay for such protection.

The risk today is that the two pillars underpinning this strategy—high hedging costs and the dollar’s safe-haven status—are being challenged simultaneously.

As shown in the chart above, major investors’ FX hedge ratios have dropped to near historic lows. Note: Aggregated quarterly data; less frequent position data is interpolated between known published values. The latest readings for Japan and Canada include model-based estimates.

As investors resume aggressive “devaluation trades”—basically, betting that US policy will erode the dollar’s value—the dollar has declined by about 2% this quarter, weakening against most G10 currencies. US Treasury Secretary Scott Besant’s support for the yen and moves to contain rising Treasury yields have further fueled these concerns; at the same time, doubts persist about whether, as Donald Trump pushes Fed Chair Walsh to cut borrowing costs, Walsh will use rate hikes to counter inflation.

FX hedges are established by selling US dollars and buying the investor’s local currency via derivatives, protecting portfolios from FX volatility. Since US assets occupy a large share of global portfolios, an increase in hedging effectively equates to more dollar selling.

Laura Cooper, London-based Head of Macro Credit at Nuveen, a unit of Invesco managing $1.4 trillion, said: “Given the sheer size of foreign holdings of US assets, even a moderate repositioning could move the market. Foreign investors hold vast amounts of US assets, so even small changes in hedge ratios can translate to meaningful FX flows.”

According to Bloomberg’s estimates, every 5-percentage-point increase in the hedge ratio for these six markets’ combined $4.6 trillion in foreign currency assets could mean around $230 billion worth of US dollar selling.

The chart above shows currency hedging conditions across major economies.

This latest estimate doesn’t cover major markets such as the UK and Eurozone, but the countries included still account for a substantial share of foreign holdings of US assets. Japan is the world’s largest foreign holder of US Treasuries, accounting for about 10% of overseas holdings, while Canada and Taiwan are also among the top ten holders.

Hedging Costs Fall, Safe Haven Attributes Waver, Two Lines of Defense for the Dollar Rarely Weaken Simultaneously

The factors that have driven hedge ratios down from over 50% over the past four years are now beginning to change.

The interest rate advantages that once made hedging expensive are narrowing. For yen-based investors, the three-month US dollar hedging cost has dropped from a high of 6% in October 2023 to 2.75%, a four-year low; for euro-based investors, hedging costs are down to 1.32%, a two-year low.

Hedging demand has reversed in the past as well. Deutsche Bank data shows that a year ago, inflows into hedged ETFs for US assets exceeded those going into unhedged funds for the first time in a decade. Now, Middle East war and surging energy prices are stoking inflation pressures, driving global central banks toward higher rates and narrowing their spread with the US.

The outlook for US rates is far less clear-cut, as Walsh’s policy communication makes it hard for investors to judge just how forcefully he will fight inflation. Last Friday at Jackson Hole, his pledge to curb price pressures prompted markets to increase rate hike expectations. Yet, investors are also weighing pressure from the Trump administration to curb borrowing costs, especially with midterm elections approaching.

Nathan Tuft, Chief Investment Officer of the Multi-Asset Solutions Team at asset management giant Manulife Investment Management, said: “If the market keeps pricing out rate hikes for the Fed and spreads narrow further, investors may rebuild those hedges—creating steady selling pressure on the dollar.”

“As policy and fiscal creditworthiness replace interest rate differentials as the dominant factor, the dollar’s trend has become increasingly decoupled from nominal and real yields,” said Tatiana Dali, Senior Markets Live Strategist at Bloomberg.

Stuart Simmons, Head of Multi-Asset Solutions at QIC Ltd., one of Australia’s largest state asset managers, said that using a foreign currency basket with 70% US dollar exposure as a defensive tool may no longer be effective.

“In an era of rising geopolitical uncertainty, can you really be sure the dollar will remain the main defensive currency in the future?” Simmons added, “Our advice is, look for other alternatives in the market and ensure your FX basket is well diversified internally.”

As shown above, US dollar hedging costs have fallen—three-month dollar hedging costs are dropping rapidly.

The dollar’s dominance is under growing scrutiny. The US Treasury’s plan to boost long-term Treasury purchases to keep borrowing costs low, and the US-Japan coordination on yen intervention, have raised market concerns: are the authorities willing to support markets and other currencies at the dollar’s expense?

Noureddine Al-Hamouri, Chief Market Strategist at Dubai’s Equiti Group, said: “If investors lose confidence in the dollar’s ability to appreciate reliably in times of market stress, they may no longer tolerate large unhedged FX exposures.”

Investors do not need to sell their US assets. They can continue to hold stocks or Treasuries while increasing FX hedges via forward-selling dollars. He added, “This distinction is important as it means demand for US assets can remain fairly robust even if the dollar faces pressure.”

Japan May Trigger Re-Hedging, Euro Awaits to Absorb Dollar Spillover

Japan, as home to some of the largest foreign holders of US assets, has the greatest potential to shift toward increasing hedges. Deutsche Bank’s estimates show a similar trend for Japanese investors: In the first half of this year, they hedged only 41% of new purchases of overseas sovereign or corporate bonds, well below the 62% seen in 2024.

Shoki Omori, Chief Fixed Income Strategist for Deutsche Bank in Japan, observed: “The last time hedge ratios were this thin was 2013, when the dollar was entering a decade-long bull run. Today's macro environment is almost a mirror image—a full reversal.”

Omori identifies three potential catalysts: further rate hikes by the Bank of Japan (narrowing the yield gap), a sharp dollar drop leading to large losses and forcing Japanese insurers’ risk committees to demand more protection, and new solvency regulations lowering Japanese insurance giants’ risk appetite for currency volatility.

The above chart shows that global investor holdings of US assets are at a record high—based on foreign investor holdings of US assets.

Eric Nelson, Senior Strategist at Wells Fargo, cautions against viewing hedging activity as a driver for the dollar’s fundamentals—over the longer term, monetary policy may still hold sway. However, he believes that as the cost to short the dollar drops, investors have room to add more USD hedge exposure.

Nelson expects the euro to be the main beneficiary, given the large amount of unhedged US equities held by European funds. “Once the dollar shows signs of underperformance in a risk-off environment, FX hedging activity could shift quickly, accelerating a sharp drop in the dollar index.”