MNI INTERVIEW: FX Hedging Could Weaken Dollar, Scale Unclear

Rising demand among global investors for hedging dollar exposures can weaken the U.S. currency, but understanding the magnitude of that effect requires more empirical analysis, University of Pennsylvania Wharton School economist Amy Wang Huber told MNI, after the BIS and others cited hedging as a key force behind recent dollar depreciation.

President Donald Trump's on-and-off tariffs policy has pushed currency volatility to new highs and boosted demand for FX forwards and swaps, the use of which had already been climbing in tandem with foreign investments in dollar assets over the past two decades, according to research by Huber and Wenxin Du of Columbia University. 

Demand pressure from hedgers can distort the pricing of FX derivatives, where deviations from no-arbitrage benchmarks like covered interest parity are well documented, as well as spot pricing, Huber said. "But to what magnitude? That's my ongoing research question." 

The argument that dollar hedging was a significant factor behind the U.S. currency’s slide in April, set out in a Bank for International Settlements paper last month, is "plausible," as participants cover future currency exposures by selling in the spot market, but so far lacks empirical evidence, she said. 

"I haven’t seen data that would clearly pinpoint hedging as the main driver," she said. "It’s possible and the mechanism exists, but quantitatively I think the jury is still out." 

The sharp selloff could instead be explained, at least in part, by a decline in expectations for the value of the currency, Huber said. The dollar index plunged 2% on April 3, a day after Trump unveiled sweeping tariffs on most trading partners. 

"How much hedging demand would you have to have, that’s abnormal from baseline, that’s also not willing to be absorbed by other market participants on that particular day? And there’s no offsetting trades in the spot market?" she said. "I’m not ruling it out. But I also think there are other channels that could explain the depreciation. You just need one sale that transacts at a lower price to set a marginal price at a lower level."  

SYNTHETIC LOCAL ASSET

One reason annual spending on dollar hedging by insurers, pension funds and mutual funds has surpassed USD2 trillion is that investors are simultaneously growing wealthier and finding too few local currency assets in which to invest. 

"They have a larger portfolio they have to deploy, and reality is they can’t all have that in foreign currency. If the local market does not offer them a sufficient amount of investment assets, they have to look abroad. When they do, they're effectively synthetically engineering a local asset by hedging out the FX exposure."  

Just how much synthetic dollar funding global investors demand and how costly it is to synthetically fund the dollar are topics Huber is analyzing now, but it seems clear more hedging will make getting synthetic dollars much more expensive, at least in the short run, she said. 

"In the long run, if we realize there’s a lot more demand, maybe regulations will loosen or banks will shift capital to meet that rising demand. So to what extent this is a permanent imbalance is much harder to say."