A scrutiny of disclosures from pension funds and insurance companies around the world reveals a growing risk facing the US dollar: some of the largest holders of US assets now have limited levels of protection against currency depreciation, which could make the dollar more vulnerable to a sharp fall if investor sentiment suddenly changes.
Calculations by Bloomberg, based on data from six markets where such figures are available, show that investors in markets including Japan, Canada and Taiwan hedged only about 41 percent of their foreign currency exposure as of June 30, the lowest level since at least 2015.
The figure may seem like just a technical detail in the currency market, but it has much bigger implications.
According to Bloomberg estimates, a hedging ratio increase of just 5 percentage points could mean transactions of around $230 billion, based on roughly $4.6 trillion in foreign currency holdings in the six markets, which also include Australia, Denmark, and Finland.
Therefore, a limited shift in investor behavior could unleash massive flows in the currency market, increasing pressure on the dollar.
Selling dollars does not mean abandoning American assets.
Most importantly, investors do not need to sell their stocks or US Treasury bonds in order to put pressure on the dollar.
An investor can hold onto US assets while simultaneously increasing hedging against currency risk by selling dollars forward against their local currency.
This means that demand for US assets can remain relatively strong, even as the dollar itself comes under increasing selling pressure.
Laura Cooper, head of macro credit at Nuveen, told Bloomberg News that the sheer size of foreign investors' holdings of U.S. assets means that even a small change in hedging ratios could lead to large inflows into the foreign exchange market.
Japan is the largest foreign holder of US Treasury bonds, accounting for about 10 percent of foreign holdings, while Canada and Taiwan are among the top ten holders.
Why did investors shy away from hedging?
Reducing hedging made sense for investors for most of the past decade. The dollar tended to rise, or at least stay strong, when markets became turbulent, providing additional protection for investors who owned US stocks and bonds.
When the value of these assets was converted into the local currencies of the investors, the rise in the dollar helped to mitigate losses resulting from the decline in asset prices.
At the same time, the cost of hedging was high, which reduced the incentive for investors to pay more for protection they did not see as urgently needed.
But two key pillars that underpinned this strategy are now being tested: the rising cost of hedging and the dollar's status as a safe haven.
The dollar weakens... and the cost of hedging declines.
The dollar has fallen by about 2.3 percent during the current quarter and has declined against most of the G10 currencies, as investors revive what is known as the Debasement Trade, the belief that US policies could lead to a decline in the value of the dollar in the long term.
It is worth noting that the Debasement Trade is an investment strategy based on buying tangible or limited-supply assets to protect wealth from the decline in the purchasing power of currencies, resulting from high inflation, excessive money printing, and the accumulation of government debt.
At the same time, the cost of hedging against the dollar has begun to decline, making portfolio protection against currency fluctuations more attractive.
The cost of hedging against the dollar for three months for investors whose investments are based on the yen has fallen to 2.75 percent, the lowest level in four years, compared to a peak of 6 percent in October 2023.
As for investors whose investments are based on the euro, the cost has fallen to 1.32 percent, the lowest level in two years.
Herein lies the paradox: the factor that was driving investors not to hedge is beginning to decline, while, on the other hand, the reasons that might drive them to hedge are increasing.
Iran war adds a new factor
These shifts come at a time when the war in Iran and rising energy prices are adding new pressure on inflation.
This is pushing central banks around the world towards higher interest rates, narrowing the gap with the United States and weakening one of the pillars that has supported the dollar's appeal over the past years.
In contrast, the path of US interest rates has become less clear.
Federal Reserve Chairman Kevin Warsh's pledge, during the Jackson Hole meetings, to curb price pressures has strengthened expectations of interest rate hikes.
But investors are also taking into account the pressure from President Donald Trump's administration to keep borrowing costs under control, especially with the midterm congressional elections approaching.
Nathan Thof, chief investment officer of the multi-asset solutions team at Manulife Investment Management, said that if markets continue to reduce their expectations for a US interest rate hike and interest rate differentials narrow, investors may begin to rebuild their hedges.
He added that this would create a continuous source of pressure to sell off the dollar.
Is the dollar losing its status as a safe haven?
It's not just about interest rate differentials. The dollar's role as a defensive tool during periods of market turmoil is also beginning to be tested.
Stuart Simmons, head of multi-asset solutions at Australian asset management firm QIC, told Bloomberg News that relying on a basket of foreign currencies in which the dollar is represented by about 70 percent as a defensive tool may not necessarily work in the future.
He added that the heightened geopolitical uncertainty raises a fundamental question: Can investors remain confident that the dollar will always be the primary hedge during periods of tension?
Simmons believes that investors should look at alternatives and achieve greater diversification within their foreign currency portfolios.
The strength of the dollar itself is also being tested by the actions of the US and Japanese authorities.
The U.S. Treasury's plan to increase its purchases of long-term debt to contain borrowing costs, along with coordinated U.S.-Japan intervention to support the yen, has raised concerns about the authorities' willingness to support other markets and currencies even at the expense of the dollar.
Noureddine Hamouri, chief market strategist at Equiti Group in Dubai, said that declining investor confidence in the dollar's ability to rise reliably during periods of market stress may prompt them to reduce their unhedged exposure to the US currency.
Hedging may shift from a secondary strategy to a necessity.
The demand for hedging had already undergone a sharp shift. Last year, for the first time this decade, inflows into dollar-hedged exchange-traded funds (ETFs) that invest in US assets exceeded inflows into non-hedged funds, according to data from Deutsche Bank.
But after the wave of hedging subsided, investors returned to lower levels of protection.
Now the equation is changing again. If the dollar continues to decline, or its volatility widens, pension funds and insurance companies may find themselves forced to increase hedging, not to speculate on the dollar, but to protect the value of their assets in local currencies.
Here, increased hedging may turn from an investment option into a risk management measure.
Japan: A Potential Turning Point
Japan may be the most important market in this equation, given the size of its holdings of US assets.
Deutsche Bank estimates show that Japanese investors hedged about 41 percent of their new purchases of foreign bonds during the first half of the year, compared to 62 percent in 2024.
Shoki Omori, the bank's chief fixed income strategist for Japan, said the last time hedging levels were this low was in 2013, when the dollar was at the start of a ten-year rally.
Omori believes that the overall economic picture today looks closer to the opposite direction.
It identifies three factors that may prompt Japanese investors to increase their hedging against the dollar.
First, further interest rate hikes by the Bank of Japan will narrow the interest rate differential with the United States.
Secondly, a sharp drop in the dollar could deepen losses and prompt investors' risk management committees to increase their protection levels.
Third, the implementation of a new solvency system may make insurance companies less willing to withstand currency fluctuations.
The euro may be the biggest beneficiary
For his part, Eric Nelson, a strategist at Wells Fargo, warned against treating hedging as a primary driver of the dollar, noting that monetary policy will remain the dominant factor in the long term.
But at the same time, he sees room for investors to increase their dollar hedges as the cost of betting on a currency decline decreases.
Nelson expects the euro to be one of the biggest beneficiaries, given the large purchases of US stocks by unhedged European funds.
He said that any signs of dollar weakness during periods of risk aversion could lead to a rapid shift in investor behavior towards hedging against currency risks, which could accelerate the dollar's decline.
The danger lies not in investors fleeing, but in a change in their behavior.
The dollar does not need a mass exodus from US stocks and bonds to come under significant pressure.
With trillions of dollars of U.S. assets in the hands of foreign investors, a small change in hedging ratios could be enough to unleash hundreds of billions of dollars in the currency market.
With the cost of hedging declining, concerns rising about inflation and interest rates, and growing doubts about the dollar's ability to maintain its role as a safe haven, the stage seems set for investors to reconsider the extent of their unhedged exposure to the US currency.
The question in the next phase may not be whether investors will sell US assets, but how many dollars they will sell to hedge against the risks of holding those assets.
