Incentives Favor Hedge-Related Selling
At present, the incentives for international investors have shifted meaningfully toward an increase in hedge ratios, which involve significant US dollar selling. Just 12-18 months ago it cost European and Japanese investors at least 2%-3% to hedge US assets. Since the US dollar tended to hold up well during equity markets sell-offs, the unhedged US dollar position used to provide some measure of equity downside protection (albeit not so much for Japan-based investors). Now, the hedging calculus has changed. Global yields have converged toward zero and the cost of hedging is very low – under 30 bp for a Japanese investor, 65 bp for a European investor and only 6 bp for a UK-based investor.
The potential for downside diversification has also reduced. The truly explosive moves higher in US dollar during a crisis, such as the one in March 2020, tend to happen when there is a US dollar funding crisis. But central banks led by the Fed have flooded the US dollar funding markets with liquidity via cross-currency swap lines. This excess liquidity not only further reduces the cost of hedging but also helps in limiting the potential for US dollar upside in times of crisis.
Another important factor is the broader monetary and fiscal support, which will help alleviate downside risks in financial assets. To be sure, we expect periods of volatility, but the policy support infrastructure in place should prevent undue surprises. With lesser diversification benefits from holding unhedged US dollars, worries about the headwinds faced by the US as well as much lower costs of hedging, why not increase hedges? Or, if you are a US investor, why not reduce foreign hedges?
US Dollar Unlikely to Lose Its Reserve Currency Status
While we expect a transition to a US dollar bear market, we do not see the greenback losing its reserve currency status any time soon. However, such a possibility warrants discussion as it will weigh on US dollar sentiment and trigger bouts of volatility.
Global investors may lose confidence in the US dollar due to a combination of factors: the growing US fiscal and current account deficits; higher future taxes restricting capital available for private investments; the US dollar’s reserve status being instrumentalized for financial sanctions; and the Chinese renminbi gradually taking a greater role in the global financial system. Each of these factors has become modestly more valid than in the past.
In practice, displacing the US dollar as a reserve currency would take a long time since the US dollar is imbedded in global business and trading activities as the principal invoicing currency, financing currency and global reserve. In addition, switching to a multi-currency world assumes an increase in the cost and complexity of managing several currency exposures. This means, the benefits of choosing an alternative reserve currency or currencies would need to be significant enough to provoke such a paradigmatic shift.
At this time, we do not see a clearly better alternative for the next cycle. The euro has negative yields, a distinct disincentive to holding it, and the long run future of the currency is still in doubt. The renminbi, on the other hand, is heavily restricted and, if anything, the developed world is growing more concerned with China’s trade and economic policies. Beijing’s control over its currency and financial markets are unlike to change.
This is in contrast to the US, which continues to have the largest and freest capital markets in the world – one important reason why the US dollar would continue to remain as the preeminent reserve currency of the world. Correspondingly, we think that the twin deficits at this point do not push the US anywhere close to a severe credit event, and as a result, it is hard for us to see a doomsday scenario developing anytime soon.
We recommend that long-term investors and strategic currency hedgers begin to position themselves for a new bear market cycle in the US dollar. As pointed out above, a US dollar bear market cycle is a long-lived affair – in the range of 7 to 10 years – and usually starts slowly. We do not anticipate a runaway, one-direction move lower considering the global uncertainties of COVID-19, potential short-run volatility and the power of monetary and fiscal stimulus to goad economic growth. In the end, we expect a combination of strategic shorting of US dollar, limiting positive US dollar positions and short-term tactical moves to serve investors well.
In our view:
- Non-US dollar based investors could increase their strategic dollar hedges
- US-based investors could reduce foreign currency hedges and book profit after a decade of hedging gains
- Risk-averse investors could buy the Japanese yen against the US dollar – this should provide a conservative way to gain exposure to a dollar bear market while hedging risks of market volatility
- Gold may also serve this purpose as it tends to do well in times of crisis and during US dollar bear markets
- Equity investors should carefully consider the impact of sustained US dollar weakness on company earnings