Macro Pulse for July 13: Dollar Demand Disrupted, Part 3 – When Hedging Gets Hard

This week, we’re focused on how relative dollar weakness – and the cost of hedging it – is filtering through global portfolios. In short, currency volatility isn’t just a side effect of macro uncertainty; it's becoming a major driver of portfolio performance.

Hedging decisions depend on who you are – and where you are

Currency hedging behavior varies by investor type and home country:

• Pensions and insurers tend to hedge bonds more tightly. That’s a function of regulation and liability matching – currency mismatch is a solvency risk.
• Asset managers and hedge funds typically face fewer constraints, and leave more FX risk open, particularly in equities where volatility tends to swamp currency moves.
• Equities are less hedged overall, in part because the dollar has historically helped in down markets. But, as we describe above, that protective relationship is fraying.

An investor’s home country monetary policy matters too. Japan’s low relative rates have made hedging U.S. exposure especially costly, and European investors face now similar different calculus. With the ECB cutting ahead of the Fed, the interest rate gap is widening – making hedging more expensive for euro-based investors.

The dollar is everywhere – and investors are feeling it

 U.S.-based assets dominate global benchmarks: 65% of MSCI All Country World Index (ACWI, an equity benchmark) and 40% of the Bloomberg Global Aggregate (AGG, a bond benchmark). That means the dollar drives not just returns, but risk. When ex-U.S. investors are buying global benchmarks, then, they’re taking on significant U.S. asset and therefore U.S. dollar exposure.  According to recent BIS research, foreign exchange (FX) risk now accounts for nearly a quarter of total risk in a typical European multi-asset portfolio.

This is a challenge that Japanese investors are familiar with. A weak yen and low local rates have made dollar exposure a key risk factor for years. But for European allocators, it’s a more recent development – and it’s happening just as the dollar is becoming less reliable as a hedge.

Historically, the U.S. dollar’s “safe haven” status has meant that selloffs in risk assets (e.g. equities) have coincided with purchases of U.S. Treasuries and therefore dollars – prompting a stronger dollar. But so far this year, the dollar has fallen alongside U.S. equities more than twice as often as over the prior decade. That’s a breakdown in one of the most relied-on cross-asset relationships. When U.S. equities sell off and the dollar doesn’t rally, the case for running unhedged exposure gets a lot weaker.

The yield curve does more than signal recession risk

Most FX hedges are short-term: one to three months for the average investor, and six to twelve months for even the longest-duration investors (e.g. insurance companies, sovereign wealth funds). This means the cost of hedging is tied to the difference in interest rates along those short-term time horizons.

Earlier in the cycle, a flat or inverted U.S. yield curve made things worse – forcing portfolio managers to use expensive short-term dollars to hedge longer-dated securities with limited yield pickup. While the curve has recently steepened, it remains relatively flat by historical standards, limiting the appeal of hedging long-duration U.S. bonds for foreign investors. At the same time, steep curves abroad – like in Japan – make holding local bonds more attractive on a relative basis. Those curve dynamics feed directly into FX positioning.

We’re already seeing signs of how these dynamics play out in currency markets. The chart below shows that the euro carry index has fallen sharply since the start of the year, suggesting that carry trades funded with euros are no longer working – likely due to a stronger euro or a shift away from USD risk. Meanwhile, the yen carry index is rising, reflecting continued comfort with borrowing in yen to chase higher yields. The divergence underscores a broader market preference for using yen, not euros, as the funding currency of choice.

The result? We could see even more volatility in currency markets – and in the returns of global portfolios.

Portfolio strategy

The recent dollar weakness has reshuffled the FX calculus. This isn’t about making a macro call on the dollar – it’s about understanding how it behaves in a portfolio.

Here’s how we’re thinking about it:

• For non-U.S. investors: High hedge costs aren’t a reason to stay unhedged. With the dollar falling and its correlations breaking down, the risk of doing nothing is rising. Consider a higher hedge ratio, particularly in fixed income. Partial hedges can help manage cost while reducing drawdown risk.
• For U.S. investors: The math cuts the other way. If you're investing abroad, especially in lower-beta markets (that is, where the assets are less volatile than the market) or defensive currencies like JPY and CHF, unhedged positions may offer more upside. The weaker dollar means FX could be a return lever – not just a risk.
• By region: European investors are already seeing better return outcomes from FX-hedged U.S. equities. In Japan, high carry still discourages full hedging – but that could change fast if the Fed cuts rates or the BoJ normalizes.