FX Hedging with a Falling Dollar

After years of strong gains the US dollar (DXY) has dropped by 10% from the high established in September 2022.? During 2023 and 2024 the dollar has traded in a broad range, largely driven by changing expectations for Federal Reserve policy. It is now clear that the Fed will formally embark on an easing cycle (lowering interest rates) starting this month. Fed Funds futures markets are pricing in a high likelihood (88%) that by December rates will be 100 basis points lower than the current 5.5%. Expectations for lower rates have helped to drive the dollar lower against most major currencies, with the primary beneficiary being the Japanese yen. Most indicators suggest that the weakness in the dollar is likely to persist for at least the next several years. That means that risk has shifted from dollar strength to dollar weakness, and hedgers need to adapt their strategies accordingly.

Long Term Trend for Dollar Points Lower

Over the last 50 years the dollar has had trends up and down that usually persist for between 7 and 10 years. The recent upmove in the dollar started from the 2008 low, meaning that the trend lasted until the high reached in 2022, for a total of 14 years duration. Many analysts note that the uptrend was extended by the effects of the pandemic, particularly the ensuing inflation and US monetary policy response of raising interest rates to 20-year highs. In any case the trend exceeded prior moves higher both in terms of time and percentage gains. Markets tend to act like pendulums, meaning that an outsize move in one direction eventually results in swing in the opposite direction. Long term technical indicators suggest that the dollar has now entered what will most likely be a multi-year bear market.

A Challenging FX Environment

·??????? Hedging against a falling dollar is potentially more difficult than a rising dollar because the US has maintained higher interest rates than those of most other industrialized nations. That means that hedgers will be paying the interest rate differential to buy protection against a lower dollar.? The expected drop in US interest rates will reduce the inter-currency rate differential, but the US will most likely maintain rates that are higher than those in the Eurozone, Great Britain, Canada, and Japan.

·??????? The dollar’s performance in FX markets will be mixed. Most currencies will appreciate, but some will lose ground against the greenback. The Mexican peso, a recent FX market standout, has dropped by over 20% during the same time most currencies have risen. That means that each currency must be evaluated on its own when considering a hedging strategy.

·??????? The dollar remains the reserve currency of the world. Investors still flock to the dollar in times of economic or geopolitical uncertainty. That means that during the course of a long-term dollar downtrend there will undoubtedly be brief periods of strength. Hedgers should view short-term rallies as an opportunity to implement hedges at advantageous levels.

Be Prepared

No one knows where the dollar will be in 12 months. Long term trends in currencies are notoriously persistent, and many of the underlying economic factors still favor the dollar. The road to a lower dollar will be bumpy. Companies with FX market exposure should do a comprehensive risk analysis to identify potential areas of vulnerability. The next step is to develop a plan to mitigate or minimize any negative impact.