Shift in hedging behavior reflects anticipation of prolonged dollar weakness: BoE's FSR

While dollar-denominated US risky asset valuations have mostly recovered since early April, the value of the US dollar remains weaker, according to Bank of Englands financial stability report. At the time of the FPCs June policy meeting, the US dollar exchange rate index was 5% below its early April level and 8% down since the November FSR, at close to a three-year low.

Since late February 2025, there has been a notable change in the usual correlation patterns between the dollar and other US assets, including equities and government bond yields, the report noted. Historically, when risky asset prices are falling during times of global stress, or when US Treasury yields are rising, the dollar has tended to strengthen. This means non-US investors have often left some of their equity positions unhedged on a currency basis because they expect the dollar to provide portfolio diversification benefits by rising if stocks fall, or if US Treasury yields rise.

But in recent months, these correlations appear to have shifted, increasing the riskiness of unhedged US dollar assets for foreign investors. The trend first emerged in February when weaker macroeconomic data prompted concerns among market participants that activity in the US economy was slowing down at a faster rate than expected. US equities began to decline, and long positions in US dollar futures fell, albeit while remaining at historically stretched levels according to Commodity Futures Trading Commission (CFTC) data. These moves were further accelerated by deterioration in sentiment toward US assets following the initial US tariff announcement on 2 April.

Market contacts report that foreign investors have been increasing their hedging of currency exposures on US assets in recent weeks by selling dollars and buying home currency to guard against further dollar weakness. This shift in hedging behaviour may contribute to downward pressure on the dollar on a continuing basis. The historic under-hedging and slow-moving nature of some of these investors suggests this could be a gradual process. Market contacts report increased positioning among hedge funds anticipating future dollar weakening due to the expectation that these hedging flows will continue.

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