Hedgers Contributed to Dollar Weakness: BIS Study

A paper in the latest issue of the Bank for International Settlements’ Bulletin, looks at the role of currency hedgers in the latest bout of dollar weakness during April and May, and also seeks to identify the key regions from which that hedging came.

Observing that the “triple decline” in equities, bonds and the dollar was “unusual”, the report, authored by Hyun Song Shin, Philip Wooldridge and Dora Xia from the BIS, suggests currency hedging from non-US investors, may have contributed to the rare dollar decline in a “risk-off” market regime. The report also notes that the dollar weakness was initially put down to a loss of confidence in dollar assets and a diminished role for the currency in global markets, however, the authors argue a “more plausible” explanation is the level of hedging activity.

After a sustained period of not doing so, due to the dollar’s strength, the report says that non-US investors retained their holding of dollar assets during the market decline, but started putting FX swap and outright forward overlays in place. It adds that the largest declines in the dollar came during Asian hours, suggesting investors in that region played a major role.

The report points out that high hedging costs and the prolonged bullish view on the dollar in recent years have led to historically low hedge ratios, with European investors reportedly reducing, and Japanese life insurers dropping from 60% to 40%. In April, however, faced with the dollar’s decline (and it can be argued that contrary to their earlier argument, this fall could have been triggered by a loss of confidence in US markets) investors started ex-post hedging, meaning they started selling after buying the dollar bonds, meaning the purchase and sale were not matched.

The report cites data showing that changes in the cross-currency basis between March and April/May 2025 are consistent with higher demand to hedge dollar investments, and that for several Asian currencies and the euro, the basis against the US dollar declined in April/May, indicating that, on the back of high hedging demand, it became more expensive to hedge dollar exposures through the FX swap market.

The authors also observe that Intraday movements in the dollar, along with intraday movements in bond prices, suggest that hedging by Asian investors played a role in the dollar’s decline, in Asian hours, while the dollar fell, US Treasury securities posted gains. This suggests, they state, that the dollar’s depreciation was not correlated with the selling of US assets, at least not at a high frequency and not US government bonds.

Going forward, the authors note that the relative importance of hedging may wane as a driver of the exchange rate, because the US economic outlook in the wake of higher tariffs is likely to have a greater influence, including in discussions about strategic allocations to US assets.

That said, the authors warn that even once ex post hedging has run its course, FX hedge ratios and investors’ management of their currency exposures bear close monitoring. “The over-the-counter nature of FX swap markets and the diversity of their participants make it difficult to track the build-up of vulnerabilities, such as concentrations of unhedged FX positions,” they write. “Moreover, higher hedge ratios tend to be associated with higher maturity mismatches because the maturity of the hedging instruments is typically shorter than that of the assets being hedged.

“The consequent rollover risk exposes hedged investors to stress in dollar funding markets,” they conclude. “On several occasions, most recently during the Covid-19 crisis and most dramatically during the GFC, these markets have turned dysfunctional, requiring central bank intervention to restore their orderly functioning.”