Strong Dollar and US Election Sparks Renewed Zeal for FX Hedging

Fund managers in North America are stepping up their activities to protect their portfolios from foreign exchange volatility as event risks intensify in the second half of the year.

A newly-published study of 250 investors in the US and Canada found that 65% are planning on increasing their hedging tenors and 34% have plans to up their hedging ratios as the US presidential election looms large and threatens to spark bouts of volatility in markets. The survey was published by MillTechFX, a company that provides FX as a service.

Aside from higher volatility and event risks, investors were concerned about the impact a stronger dollar has on their positions and foreign market exposures. More than 80% of respondents said that the dollar’s upward march this year proved to headwind to profit generation with returns negatively affected.

The dollar’s strength has also upped operational costs for 81% of respondents with 34% seeing “significant” increases as a result.

“Many fund managers treat FX like people treat dentistry. When there are no signs of pain, it’s not a priority – but when the pain starts, it quickly becomes an emergency.

Fund managers that approach FX in this way need a rethink,” Eric Huttman, the CEO of MillTechFX writes in the research.

“FX can make or break fund managers’ returns and have a serious impact on operational costs, as evidenced by the findings from our research,” he adds.

At the start of August the euro is 1% weaker against the greenback than in January and the Japanese yen is sitting at multi-decade lows against the dollar, which is already forcing investors to reassess their approach to hedging. This is especially true as recent episodes of volatility underscored the need for more considered hedging approaches than in the decade of near-zero interest rates.

Fund managers are hedging more of their currency risk over a longer horizon than a year ago, despite a rise in costs. The average hedge ratio is at 55%, up from 50% a year, while tenors have risen to 5.41 months from 4.96 in 2023 despite 80% of respondents citing higher hedging costs.

The survey also found that Canadian fund managers are more likely to have changed their policies and activities as a result of the strong dollar and this cohort is more active than their US counterparts when planning to institute changes around their hedge ratios and tenors ahead of the US election.

Other issues and challenges

Aside from upping hedging activities, fund managers were keen on increasing their automation in workflow processes, with around a third of respondents considering end-to-end automation. Hand in hand with this trend is the move away from manual processing, which remains prevalent in FX operations. MillTechFX’s paper reveals that 26% still use email to make FX instructions while 24% continue to rely on the phone.

“While there is still a reliance on manual processes, it’s great to see nearly all fund managers are exploring new technologies and focusing on automating end to end FX workflows. This will not only increase efficiencies and make their lives easier, but it will also help them protect returns from external factors such as the election,” Huttman says.

The move to T+1 settlement in US equities has also forced investors to make changes around their staffing and IT systems, which translated into higher operational costs for 78% of respondents.

In terms of other operational challenges, cost calculation remains a focus for 30% while liquidity provider onboarding and securing credit lines are challenges for many. In terms of priorities, FX counterparty credit and uncollateralized hedging lead the way.

“As we navigate through dynamic market conditions and pivotal political events, a diligent and forward-thinking approach to FX hedging will be crucial for avoiding pain, protecting returns and achieving sustainable success,” Huttman says.