Global investors' US dollar hedging ratio hits a ten-year low, increasing selling pressure on the dollar

Major global institutional investors hold massive amounts of U.S. assets but have virtually no protection against dollar depreciation, a dynamic that is planting systemic risks for the greenback.

According to Bloomberg's estimates based on data from six markets, as of June 30 this year, the currency hedge ratio of pension and insurance funds in key markets such as Japan and Canada was only 41%, the lowest level since 2015.

This means that if market sentiment reverses, large-scale rebuilding of hedges could directly translate into selling pressure on the dollar. Bloomberg estimates that the combined foreign currency holdings across these six markets total around $4.6 trillion. For every 5 percentage point rise in the hedge ratio, it will trigger trading volumes of about $230 billion.

Currently, the two main pillars supporting low hedge strategies—high hedging costs and the dollar’s safe-haven status—are being simultaneously challenged. The dollar has weakened against all G10 currencies this quarter, with a cumulative decline of about 2.6%.

At the same time, investors are confused about the Federal Reserve’s rate hike path, the U.S. Treasury’s efforts to support the long end of the bond market, and a declining safe-haven appeal for the dollar, all of which are fueling increased bets on a "dollar depreciation trade."

Over the past decade, institutional investors have generally chosen to hold a large amount of unhedged dollar assets, under the logic that: the dollar usually appreciates during market turmoil, naturally providing a risk buffer; and high hedging costs mean that active protection is not worthwhile.

However, the effectiveness of this strategy is being questioned. Nuveen, which manages $1.4 trillion in assets, has London-based macro credit chief Laura Cooper stating:

Given the massive holdings of U.S. assets by foreign investors, it doesn’t take a large change in hedging ratios to make a real impact. Even slight shifts in the hedge ratio can drive significant currency flows.

It is noteworthy that Bloomberg’s calculations do not yet cover major markets like the UK and the Eurozone, but the included countries already represent a substantial portion of U.S. asset holdings abroad.

Japan is the world’s largest foreign holder of U.S. Treasury bonds, accounting for about 10% of overseas holdings, while Canada also ranks in the top ten.

The key factors driving the continued decline in hedge ratios from over 50% four years ago are now quietly reversing.

The narrowing of interest rate differentials is the most direct variable. The cost for yen-based investors to hedge the dollar for three months has fallen from 6% at its peak in October 2023 to 2.75% now, a four-year low; for eurozone investors, hedging costs have dropped to 1.32%, the lowest in two years.

Manulife Investment Management’s CIO of Multi-Asset Solutions, Nathan Thooft, says:

If the market keeps pricing in expectations that the Fed will not raise rates and the differential narrows further, investors may start rebuilding their hedges. This would result in sustained selling pressure on the dollar.

At the same time, inflation pressure from the war in Iran and surging energy prices is driving global central banks towards tighter policies, further compressing the interest rate gap with the U.S. and eroding the relative appeal of holding unhedged dollar assets.

Beyond cost factors, the dollar’s structural safe-haven logic is facing deeper challenges.

The U.S. Treasury’s program of large-scale purchases of long-term bonds to suppress borrowing costs, as well as the coordinated FX intervention actions between the U.S. and Japan, have raised doubts among markets on whether American authorities are willing to sacrifice the dollar to maintain financial stability.

Equiti Group’s Chief Market Strategist Noureldeen AlHammoury points out:

If investors lose confidence that the dollar will reliably appreciate during periods of market stress, it will become much harder for them to tolerate large unhedged currency exposures.

He also stresses that investors do not need to sell the U.S. assets themselves. They can hold stocks or Treasuries and increase currency hedges by selling dollars forward. Noureldeen AlHammoury adds:

This distinction is very important because it means that even if the dollar comes under pressure, demand for U.S. assets may remain relatively robust.

Stuart Simmons, Head of Multi-Asset Solutions at QIC Ltd., one of Australia’s largest government-backed asset managers, says that relying on a foreign currency basket with 70% exposure to the dollar as a defensive tool may no longer be effective. He says:

In an era of rising geopolitical uncertainty, can you really be confident that the dollar will remain the primary defensive play? We recommend considering alternative options to ensure the foreign currency basket is better diversified.

Japan’s risk exposure is particularly noteworthy amid a potential wave of renewed hedging.

According to Deutsche Bank, Japanese investors’ hedge ratio for new purchases of overseas bonds was only 41% in the first half of this year, dropping sharply from 62% in 2024.

Shoki Omori, Chief Strategist for Japanese Fixed Income at Deutsche Bank, points out that the last time the hedge ratio was this low was in 2013, after which the dollar began a decade-long bull run. “Today’s macro environment, however, looks more like the mirror image of that period.”

Omori identifies three possible catalysts that could trigger a rebuilding of hedges:

• The Bank of Japan raises rates further, narrowing the rate differential;
• A sharp drop in the dollar deepens losses, forcing risk committees to demand additional protection;
• And new solvency regulatory frameworks limit insurance firms’ tolerance for FX volatility.

Wells Fargo strategist Erik Nelson cautions not to overstate the impact of hedging activity on the dollar, arguing that monetary policy direction remains the most dominant long-term driver.

But he also notes that, with European funds holding large unhedged U.S. equity positions and the cost of shorting the dollar dropping, there is growing room for investors to add hedges, making the euro a possible key beneficiary. Erik Nelson emphasizes:

Any sign the dollar underperforms during periods of safe-haven demand could trigger a rapid shift towards FX hedging, accelerating the dollar’s decline.