Is the "butterfly effect" in the currency market about to unfold? 41% hedging lays the groundwork for the accelerated depreciation of the US dollar, with $230 billion in sell orders poised to strike.

The key logic behind the recent resurgence of the "devaluation trade wave" surrounding the dollar is not the expectation of interest rate cuts by the Federal Reserve, but rather the simultaneous loosening of two traditional pillars supporting the dollar: on one hand, the narrowing of interest rate differentials between the U.S. and other economies reduces foreign exchange hedging costs; on the other hand, the accelerated expansion of the fiscal deficit leads to a continuous rise in the term premium of U.S. Treasury bonds, actions by the U.S. Treasury to suppress long-term Treasury yield benchmarks for financing costs, and doubts about the independence of monetary policy, all of which are undermining the credibility of the dollar as a safe-haven asset during crises. The dollar has declined by approximately 2% this quarter, and its movement is increasingly decoupling from both nominal and real yields, indicating that the market's pricing focus is shifting from "interest rate differentials" to "policy and fiscal credibility." It has been observed that the real concern of late is the unusually low foreign exchange hedging ratio among global institutional investors. As of June 30, institutional investors in markets such as Japan, Canada, and Taiwan have hedged only 41% of their foreign currency trading exposures, marking 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 potentially result in around $230 billion in large-scale dollar selling. This does not imply that investors will immediately liquidate $230 billion worth of U.S. stocks or bonds; instead, they may opt to retain U.S. assets while selling dollars and buying local currencies through derivatives like foreign exchange forwards and swaps. Therefore, this represents a potential selling pressure on the dollar's exchange rate, rather than an imminent or inevitable spot market sell-off. However, these data also constitute an asymmetric risk: the current low hedging levels do not directly depress the dollar, but once the dollar ceases to appreciate in a market risk-off environment, pension and insurance institutions may concentrate on selling dollar forward contracts, creating a negative feedback loop of "dollar depreciation additional hedging positions further dollar depreciation." This does not mean that global investors must sell their U.S. stocks or bonds. Institutions can continue to hold U.S. assets while using derivatives to sell dollars for currency hedging, thus potentially further diverging demand for U.S. assets from the dollar's trajectory. Japan could be the biggest trigger for a potential rehedging wave, while the euro may emerge as the primary beneficiary currency; however, from a long-term investment perspective, the relative policy paths of the Federal Reserve and other central banks remain fundamental pricing variables for the dollar, with further hedging likely to amplify the existing downward trend rather than independently generate a new wave of dollar bearishness. Low hedging creates potential selling pressure, dollar naked exposure risks reach historical extremes A review of disclosure documents from pension funds and insurance companies around the world reveals a particularly striking point: some of the largest holders of U.S. assets have provided little protection against dollar weakness through hedging; once market sentiment abruptly reverses, the dollar index may face a greater risk of decline. According to data collected from six markets with available relevant information as of June 30, institutional investors in Japan, Canada, and Taiwan have hedged only 41% of their foreign currency exposuresthis is the lowest level since at least 2015. While this may not provide a complete picture, it offers insight into the recent decline of the short-lived hedging frenzy arising from the extreme tariff policies pushed by former President Donald Trump, which had targeted risk hedging against dollar depreciation. As the hedging ratio declines, investors are reverting to the effective strategies utilized for most of the past decade. During periods of increased market volatility, the dollar index tends to rise or, at the very least, hold firm, thereby cushioning the losses when converting U.S. stocks and bonds back into investors local currencies. Meanwhile, due to persistently high hedging costs, investors have had little incentive to pay for such protection. The current risk lies in the fact that the two main pillars supporting this strategythe high costs of hedging and the dollar's status as a safe-haven currencyare simultaneously being challenged. As shown in the above chart, the foreign exchange hedging ratio among major investors has dropped to historically low levels. Note: Quarterly composite data; infrequent holding data are interpolated between published observations. The latest readings for Japan and Canada include model-based estimates. As investors are re-engaging in aggressive bets on "currency devaluation trades"believing that U.S. policies will erode the value of the dollarthe dollar has fallen by roughly 2% this quarter, weakening against most currencies in the G10. U.S. Treasury Secretary Scott Pelleys support for the yen and efforts to curb rising U.S. Treasury yields have further heightened these concerns; at the same time, the market is questioning whether, with Trump pushing Fed Chair Waller actively to lower borrowing costs, Waller will curb inflation through interest rate hikes. Foreign exchange hedging, through the sale of dollars and purchases of an investor's local currency via derivatives, protects investors from the impacts of currency fluctuations. Given that U.S. assets comprise a significant portion of global portfolios, an increase in hedging size ultimately signifies increased selling pressure on the dollar. Laura Cooper, head of macro credit at Nuveen, a subsidiary of Invesco managing $1.4 trillion in assets, stated, "Considering the scale of U.S. assets held by foreign investors, it wouldn't take drastic changes in positioning to impact the market. Foreign investors hold a massive amount of U.S. assets, so even a slight change in the hedging ratio can lead to materially significant foreign exchange capital flows." According to estimates by Bloomberg based on the $4.6 trillion in foreign currency assets held across these six markets, an increase of 5 percentage points in the hedging ratio by institutional investors would approximately $230 billion in dollar currency selloff. The chart above illustrates the foreign exchange hedging status of various economies. This latest estimate does not encompass major markets like the UK and Eurozone, but the included countries still represent an important portion of foreign-held U.S. assets. Japan is the largest holder of U.S. Treasury bonds abroad, accounting for about 10% of foreign holdings; Canada and Taiwan also rank among the top ten holders. The decline in hedging costs and the wavering of the dollar's safe-haven attributes indicate a rare simultaneous loosening of the dollar's two defenses. Factors that have driven the hedging ratio down from over 50% for the past four years are now beginning to change. The narrowing interest differentials that kept hedging costs high are now becoming less pronounced. For investors with yen as their base currency, the three-month dollar hedging cost has dropped from a high of 6% in October 2023 to 2.75%, hitting a four-year low; for euro-based investors, the hedging cost has fallen to 1.32%, a two-year low. Demand for hedging has also seen reversals in the past. According to Deutsche Bank, a year ago, funds flowing into dollar-hedged exchange-traded funds targeting U.S. assets for the first time exceeded those for non-hedged funds over the last decade. Now, the Iranian war and soaring energy prices are heightening inflationary pressures, prompting central banks globally to shift towards higher rates and narrowing the interest differential with the U.S. The outlook for U.S. rates is less clear; Waller's policy communication makes it difficult for investors to determine how aggressively he will combat inflation. Last Friday at Jackson Hole, he pledged to contain price pressures, which heightened market expectations of interest rate hikes. However, investors are also weighing Trump administration pressures to control borrowing costs, especially as the midterm elections approach. Nathan Tuft, Chief Investment Officer of the Multi-Asset Solutions team at Manulife Investment Management, stated, "If the market continues to withdraw its pricing of Fed rate hikes while interest differentials narrow further, investors may start to rebuild those hedging positions, creating sustained dollar sell pressure." "As policy and fiscal credibility replace interest differentials as the dominant factors, the trajectory of the dollar has become increasingly decoupled from both nominal and real yields," said Tatiana Darie, a senior strategist at Bloomberg Strategists Markets Live. Stuart Simmons, head of multi-asset solutions at QIC, one of Australia's largest government asset management firms, commented that having a foreign currency basket with a dollar exposure of up to 70% as a defensive tool may no longer be effective. Simmons remarked, "In an era of increasing geopolitical uncertainty, can you truly be confident that the dollar will remain the primary vehicle for defensive trades in the future? Our recommendation is to explore other alternatives in the market and ensure more adequate diversification within the foreign currency basket." As shown in the above chart, the dollar hedging costs have declined, with three-month dollar hedging costs experiencing a rapid drop. The strong position of the dollar is also being questioned. The U.S. Treasury's plan to increase long-term Treasury purchases to suppress borrowing costs, combined with coordinated interventions in the yen, has raised market concerns about whether authorities are willing to support markets and other currencies at the expense of the dollar. Nourdin Alhamouri, Chief Market Strategist at Dubai's Equiti Group, stated, "If investor confidence in the dollars ability to reliably appreciate during market stress declines, they may be less willing to tolerate substantial unhedged currency exposure." Investors do not have to sell their U.S. assets. They can continue holding stocks or U.S. Treasuries while increasing their currency hedging by selling dollars via forwards. He added, "This distinction is critical because it means that even if the dollar comes under pressure, demand for U.S. assets can remain relatively strong." Japan could be a triggering point for rehedging while the euro waits to absorb dollar outflows. As one of the largest overseas holders of U.S. assets, Japanese investors' shift towards increasing hedging potential may be most significant. Estimates from Deutsche Bank regarding Japanese investors show a similar trend: in the first half of this year, they hedged only 41% of the newly acquired overseas government or corporate bonds, far less than 62% in 2024. Shoji Omori, Chief Fixed Income Strategist based in Japan for Deutsche Bank, emphasized, "The last time hedging positions were this thin was in 2013 when the dollar was entering a sustained bull market that lasted a decade. Today's macro environment mirrors that time, acting as a reflection in a mirrorreversed or perfectly corresponding images." Omori identified three potential catalysts: further interest rate hikes by the Bank of Japan, narrowing interest differentials; a significant drop in the dollar leading to expanded losses and prompting major institutions like Japanese life insurers to seek more protection; and new solvency regulations that could lower Japanese insurers' tolerance for currency fluctuations. The chart illustrates that the scale of U.S. assets held by global investors has reached an all-time highbased on the U.S. assets held by foreign investors. Eric Nelson, a senior strategist at Wells Fargo, cautioned that hedging behavior should not be seen as a fundamental driver of the dollar; rather, over the long term, monetary policy may still play a dominant role. However, he believes that as the costs of shorting the dollar decrease, investors still have room to increase their dollar hedging exposure. Nelson predicts that due to significant buying of U.S. stocks by European funds without currency hedging, the euro will emerge as a major beneficiary. He stated, "Once signs emerge of the dollar performing poorly in a risk-off environment, foreign exchange hedging behavior may shift rapidly, further exacerbating the decline in the dollar index."