Why do investors love US assets, not the US dollar?

There has been much written about the role of increased hedging in pulling the US dollar down in the first half of this year. Of course, we can never know why the US dollar fell, and if it was due to FX hedging, then what caused investors to choose to raise hedge ratios? After all, the period was a very volatile one for asset prices in general, but usually these ‘risk-off’ periods lift the US dollar thanks to its safe-asset qualities, which may hint that hedge ratios customarily fall, not rise.

One explanation might have been that traders and investors were running with excessively large open long-dollar positions and decided to hedge these to pare risk as other asset prices became very volatile. If this was part of the story, the key question now and for the future is whether traders and investors are still running with ‘excessive’ long-dollar exposure, for if this is the case, the US dollar could collapse again. Of course, there’s also the opposite possibility that long-dollar positions have been pared back so much that investors will want to reduce their hedge ratios again, and that could lift the value of the US dollar.

So, what’s the evidence? Data on the futures positions of non-commercial traders as reported by the Commodity Futures Trading Commission (CFTC) does reveal that long-dollar positioning against other advanced currencies was very substantial at the start of the year. This suggests that traders and investors might have rushed to hedge long-dollar exposure when asset prices became fractured around ‘liberation day’ on April 2^nd. Fast forward to today and things appear more balanced, but not what we might call ‘over balanced’, meaning that there’s no sign traders have turned excessively short of the greenback.

Steven Barrow, Head of Standard Bank G10 Strategy might think that more balanced positioning rules out another steep slide in the US dollar but we’d not jump to conclusions. Much depends on the state of the FX market. For instance, if asset prices are starting to move (meaning fall) quickly, any dislocation of the FX market can make the exit door smaller for US dollar holders, and this can exacerbate the US dollar’s fall even if trader positioning appears more balanced.

With positioning apparently more balanced than at the start of the year, Steven Barrow turns to other factors that could lift hedge ratios still further and so put more downward pressure on the US dollar. One of these is the cost of hedging, as likely Fed rate cuts relative to the likes of the ECB and BoJ will lower the cost of hedging US asset positions for non-dollar investors. A second factor is that investors might want to press on with increasing hedge ratios further simply because they don’t like the US dollar, however much they might still like US assets such as stocks and treasuries.

For instance, if there is speculation that the Fed is goosing the economy with more rate cuts because of pressure from the White House, it would seem to make sense to love the US stock market and the front end of the treasury market but to hate the US dollar. For while stocks will be helped by Fed easing, the fact that inflation is already over target and will likely rise further reduces what we might call the ‘real’ cost of hedging even more. This is not just because a fall in nominal US rates lowers hedging costs but also because a higher inflation outlook relative to its peers undermines the US dollar as well, so making hedging look even more attractive.