Why The World Started Hedging Its US Dollar Exposure

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1:49Hello and welcome to another episode of the All Thoughts Podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, there are so many huge stories that you could pull out of this year. But I mean, like some actually really, really big ones. So we had Liberation Day and the market crash. We had the continued weakness in the U.S. dollar, which has been this sort of slow burn crash across the year. And we're recording this, let's see, October 17th and, you know, dollar down yet again. Although it is down, but however, there's been a little, you know, it hit us low in mid-September. Don't make apologies for the dollar, Joe.

2:27No, you know, I just like keep going and then I'm – All right. Keep going and then I might add something. Fall in the dollar. Yeah, the fall in the dollar is very big so far this year. But this huge ramp up in the price of gold, which seems to hit a new record all the time. And then we've had the continued strength slash resilience, whatever you want to call it, enthusiasm about AI. in the stock market. And it really seems like there's this division at the moment between how people feel about corporate America and how people feel about sovereign America in the form of its currency. You know what I really regret doing, Tracey?

3:03I really regret it. Did you have like a hoard of gold that you got rid of or something? No, I took out a gold-denominated mortgage. You know, I feel so stupid. I feel so stupid. Why did I do that? I get paid in dollars and I took out a gold-denominated mortgage, what was I thinking? No, I didn't. But had I done, that would have been a very bad trade. Yes. Remember those stories from like, you know, a little bit of a tangent. Remember all those stories from like the Hungarians? They took out those Swiss-denominated mortgages back in the 2000s. That was very much a Europe thing for a while. Yeah, that was a really funny little, we don't have to talk about that.

3:39But one thing I was just, The only reason I caveated the dollar fall, which I do think it is quite a bit down from the beginning of the year. All that being said, it is striking in the last several weeks the degree to which a few of the very popular consensus ideas for this year are turning a little bit. And I say that 10-year treasury is the time we're recording this. October 17th has fallen below 4%. How many times did you hear about the steepener trade this year? How many times did you hear about fiscal dominance losing control at the long end? The dollar, it stabilized a little bit. So it is a very interesting moment for markets in many respects right now.

4:20There's definitely a lot to talk about. Congrats on managing your personal FX liabilities. I'm doing a good job. Getting paid in dollars and paying your mortgage in dollars. Well done, Joe. All right. Well, you know, this is the kind of thing that a lot of big investors are thinking about at the moment. and we should definitely think about it too. And who is the one person that we really like to talk to when we talk about these big trends? And who is the one person that is always in town? Because we're in Washington, D.C. right now. When we go to a new town, who is the other guy who always is probably going to be there at the same time?

4:55The person that we run into on the street in various outfits. Although this time you're wearing a suit. So there we go. The last time we ran into you randomly, you were wearing hiking gear and so were we. Anyway, we are here in D.C. We have the perfect guest, as always. We are speaking once again with Hyun Sung Shin. He is the economic advisor and head of the Monetary and Economic Department at the Bank for International Settlements, the BIS. We love talking to him, and it's so great to have him here to talk about something that's really been on the minds of a lot of market participants, a lot of policymakers right now.

5:29So, Hyun, thank you so much for coming back on All Thoughts. Thank you, Tracy. Thank you, Joe. It's great to be back. Since Joe doubts my entire premise for this episode. I'm not doubting the entire premise at all. No. Let's just start with how unusual would you say this year has been? And I feel like so much has happened. We kind of have to cast our minds back to April when we did have Liberation Day and when we did see the dollar fall as the market was selling off, which was something that's not really supposed to happen. You're supposed to have investors reach for the safe haven of the greenback in times of turmoil and stress.

6:05And now, you know, fast forward to October, I think we've gotten a little bit more used to that particular dynamic. But how surprised were you at that time? Well, it was a very unusual combination of events in April. So what we saw was the so-called triple decline where you had stocks, bonds and the dollar falling in unison. And that's very unusual because in a risk-off episode, which April was, typically the dollar would rally. There would be a kind of safe haven flow. And back then, there was, of course, a lot of news. And you saw a lot of stories back then about possibly the dollar losing its international status and so on.

6:50I think in retrospect, that was quite hasty. And I think now that we have the data, we can piece together in a more kind of coherent way what was going on. And in short, I think it was a kind of hedging story where investors who had lots of exposures to the US dollar were trying to reduce some of those exposures. And we can get into some of the details of how that kind of trade might transpire. And it just so happens that this is also the year that the BIS conducts its triannual survey of FX markets. And we've just published the results. And I think we can also shed some more light on the events in April.

7:39Let's keep it big picture soon and we'll drive down into specific months and weeks. People work for the BIS. They probably must take out mortgages and Swiss francs. They're living there in Basel. Anyway, sidetrack. What are some of the big takeaways from this year's survey? Yeah, yeah. So I think, well, actually, before we go there, Joe, I mean, it's worth thinking about how FX markets really figure in the investment strategy. So if you're a long-term investor, let's say that you're a euro area pension fund. What you have are obligations to your local – In euros. Yeah, beneficiaries in euros. but you have a very large balance sheet.

8:21And so you need to have a very broad exposure to global assets, including those in non-euro denominated assets. So what tends to happen is some of the euros are then converted into dollars to invest in dollar assets. But of course, what you want to do is to make sure that you hedge that currency risk. And this is where this instrument called an FX swap really comes into its own. and it's an operation where essentially the euro area investor pledges some euros and then borrows dollars and then with those dollars then go into dollar denominated assets and as you do that you also promise to unwind that transaction at a known exchange rate that are fixed in a moment in the future so essentially once you've gone through that transaction your currency risk is hedged Now, exactly how much of your foreign portfolio you hedge in this way, that varies over time.

9:24I mean, it depends, for example, on how high the hedging costs are. Because you're typically doing this fairly short term and you're rolling over these hedges, what's important is the short-term dollar interest rate because you're borrowing dollars in order to invest in dollar assets. So when the short-term interest rate is very high, that's typically a time when hedging costs are very high. And so what had happened over the last few years was that these so-called hedge ratios, the proportion of your assets that you actually hedge, had been really trending down to the extent that some investors didn't hedge at all.

10:05And why would you if the dollar is surging and the hedging cost is so large? And so when the turbulence broke earlier in the year, a lot of investors were basically caught with very large dollar exposures, having not hedged. And I think one piece of evidence that the events of April was very much an ex-post hedging story, hedging after the fact, was that we saw a lot of the telltale signs of swaps being taken out and dollars being sold. happening in the market. So what would happen is, if an investor is holding dollar assets without a hedge, but you're concerned about the dollar falling, then what you would do is you would put on a hedge ex post.

10:55You would put on a hedge after the event. And you could do that, for example, by actually then engaging in an FX swap right there, but then selling the dollars that you've acquired. So rather than investing those dollars into dollar assets, you simply sell it in the spot market. What that kind of dynamics would imply is that there would be lots of downward pressure in those situations where institutional investors are trying to raise their hedge ratios, but exposed. So back to the triennial, what do we see there that puts additional light on this episode. Oh, by the way, on the triennial, it just so happens that the sampling period was April this year.

11:41Amazing. So it may be slightly distorted by the events of the April episode. On the other hand, the silver lining is that we have some great data on really the events of the April episode. But the headline numbers are really quite notable. It's$9.6 trillion dollars daily flow. This is something like almost 30 % higher than the previous survey in 22. The dollar is still very much the dominant currency. It's 90 % of all of the transactions have the dollar on one side. It's even higher than what we saw in 22. So in spite of the survey being affected perhaps by these stress events in April, we think we've got a very, very good sort of take.

12:33One of the things that we noticed this year is, of course, you know, as well as the FX swaps, which is by far the largest segment of the transactions, we also see a lot of a big increase in the spot transactions and also outright forwards. So let me just explain that for your listeners. You know, when you engage in an FX swap, You know, the investor would borrow dollars by pledging euros. And then there's also a promise to reverse that. Now, that promise is called a forward. And, of course, you can get that, you know, without going through the swap. You can just go to a dealer and say, look, you know, just sell me an outright forward, so-called.

13:17And then I would actually then have a dollar obligation. So a swap is like a spot trade plus a forward. Exactly. It's that combination. And what we see is, as well as the swaps, we see the two components, the spot and the forward, being very, very large this year. And we think that the events of April must have had an impact because as well as getting a swap and selling the dollars in the spot market, you can also just ask a dealer for a forward contract. But then, of course, the dealer has to hedge. So, you know, there's going to be a spot sale anyway. And so that combination would actually lead you to a situation where both the spot and the forward transactions go up a lot.

14:05And that's exactly what we see. So this is another piece of the evidence that this was very much ex-post hedging. And let me mention just two other things on this. We put out a bulletin earlier in the summer. We lay out all the other pieces of evidence that we could gather. But it's also notable that if you look at the actual portfolio flow numbers, the international portfolio flow numbers, there was no real selling in April. So, you know, there was a very, very small outflow. But on the scale of things, it was really tiny. There was certainly no, you know, concerted portfolio outflows, you know, from the US.

14:42So that's really, I think, perhaps the most compelling evidence that the so-called sell America trade was not the story behind the April episode.

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17:10Why should we care either qualitatively or quantitatively if this was a hedge America story and not a sell America story outright? Over the long term, it is possible that long-term investors would then reassess their global exposures. And you hear a lot of anecdotal evidence that these conversations are going on. But so far, that hasn't really been translated into actions. But I think what does flow very clearly from the actions in the spring is that when we look at the various pieces of the global financial system, every part depends on other parts. And there is this network effect where provided that everyone else is doing what they're doing around the US dollar, then it's also in my interest to actually be part of that ecosystem.

18:05So if you have this kind of network effect, it's very difficult to have this wholesale shift away. One of the things that I think is unusual, and I probably said this in a few other episodes, but what I think is striking about this environment is that if you look at the US, you can come up with a long list of reasons to be concerned, which we don't need to come down, recapitulate. Now, on the other hand, the most profitable, impressive, cutting-edge companies in the world that everyone would love to have exposure to in some way are in the US. And it strikes me as that's the unusual situation, which is we don't typically associate volatile sovereigns with being the home of the most dynamic companies in the world.

18:51And so to my mind, I would love to have more exposure to NVIDIA and Microsoft and all of these companies that are making money hand over fist without having exposure to the US itself. And hence, I might want to hedge. I mean, certainly, you know, the equity market story, I mean, that really is in a class of its own. And as you say, that's really been a very, very strong theme. But more broadly, you know, capital markets, if you think about how capital markets operate, there's a whole ecosystem behind that. And you have the underlying securities, obviously, but then you have the hedging instruments.

19:26And then you have a whole set of investors who are actually taking part. And the banking system is absolutely crucial in providing those hedging services. And I think when we last discussed this back in Jackson Hole, we talked about how the FX swap market makes money fungible across currencies. And money is ultimately something to do with banks. So the central bank issues high-powered money. Commercial banks are there also to issue money that the other users will take advantage of. And FX swaps are there basically providing this service of making money fungible across currencies. So every piece fits into every other piece in that sense.

20:15And so we should think about this in terms of the mutually reinforcing pieces of this network. What have you observed in terms of the actual trends in FX hedging costs? Because as you described it, in April, suddenly it all starts kicking off. a lot of large investors who are not that used, perhaps, to having to hedge their dollar exposure suddenly scramble to do it ex post. As you described, did that mean that the cost of actually doing so actually increased or was it still relatively cheap? Well, actually, it's primarily about how high the short-term interest rates are, actually. And in particular, if you're a non-US investor investing in dollar assets, it's really how high the short-term dollar interest rate is.

21:03Because essentially, what we're doing is, you know, you're pledging euros, let's say, and then borrowing dollars short term, and then investing in dollar assets. And so it's really about how high that short term interest rate is relative to the yield you're getting on the asset itself. And so if you have a flat yield curve, you know, which is what we've had, or even inverted yield curve, then hedging costs are very high. And so in fact, you know, investors have typically hedged. And hedge ratios have fluctuated. There's no systematic survey, but it's fluctuated between 40 % and 60%. I mean, there are some pockets of official data like the Japanese life insurance companies.

21:42But typically, this is really quite anecdotal. But what had happened in the last year or so was the hedge ratios had gone down gradually. Some firms were not even hedging at all. They were trying to win both on the stronger dollar, but also on the high yields. Actually, let me just mention a very interesting point here, actually. It's actually worth thinking about the parallels between this story about advanced economy, investors holding US dollar assets, with the story about local currency emerging market bonds. That's actually a very, very important asset class that really grew up after the GFC.

22:27And that's typically an asset class where the investor would not hedge. So if you want to enter into a large emerging market sovereign bond trade, you would actually buy the instrument on an unhedged basis. And you do that because you think the emerging market currency will appreciate as well as the yield fall, and so you win twice. You gain both on the yield as well as on the exchange rate. But of course, when the tide turns, that's when you scramble to hedge ex-post. And that's exactly the same type of thing that we saw in this episode. And there were actually emerging market investors, especially from Asia, who were caught with very low hedge ratios.

23:17and there was this ex-post hedging going on. So there's actually a very interesting parallel between what was going on this April and the much older trade, which is the emerging market trade. So Joe, on the plus side, people aren't necessarily selling dollar assets. On the downside, the negative side, we're basically treating dollar assets the way we would a local emerging market bond. People are like, I think I'm going to buy some local currency USD. That's right. But like – so what was it about April then that caused the – like what – I mean we know there was – they launched a trade war and there were like massive tariffs, etc.

23:58But like what was it about that such that people's impulses to hedge more, ex post facto as you've described it, what was the thing that said, oh, we want to change our sort of – our exposure to US dollars even if we don't want to sell them? I think it's probably a combination of several things. But where the investors found themselves in terms of the hedge ratios had a lot to do with this. Actually, if you look through your Bloomberg News database, you'll find plenty of stories from 23, 24, where, let's say, life insurance companies announced that they will not be hedging. you know the so you know they would be holding uh let's say us dollar assets but without a hedge and as i said you know there were some firms that didn't hedge at all and in a risk-off environment what typically happens that you want to take some chips off the table uh and that just means reducing your exposure yeah and if you're exposed you know in this double whammy fashion uh you know you would actually try and either hedge ex post or reduce your exposure.

25:12It looks like from the evidence that it was very much the ex post hedging story. So if people are hedging their dollar exposure more than perhaps some of them at least used to, do we have to worry about things like rollover risk or some sort of, I guess, duration mismatched, where you have a short-term hedge, whether it's a forward or a swap or whatever, mismatched to a longer-term asset. I mean, this is what the BIS does on a day-to-day basis, is worry about potential risks. So are you worried here? That's a really great comment, Tracy. And I think this was where I was going to go next. Of course, you have this, you know, once you hedge, you've hedged the currency risk at least until the maturity of the swap, which is typically, you know, one month to three months.

26:07But it's a short-term liability that you need to roll over. And from time to time, you might get caught in a liquidity, you know, stress episode where it's difficult to source the dollars to actually repay. And this was, for example, what happened during the GFC. It's also what happened during March 2020 when there was also a scramble for dollars. And when you're a long-term investor, you've hedged using a short-term FX swap, but you're holding long-term securities, you have a maturity mismatch. So either you have to somehow sell your long-term assets, which is going to be very difficult at a fair price, or you have to join the scramble for dollars with all the other borrowers of dollars in the market.

26:59And so this is the paradox where you're a long-term investor, but actually you have this short-term dollar obligation. And so we are swapping one – well, we are actually exchanging one type of risk for another. We're actually changing currency mismatch for maturity mismatch. And empirically, if you look at the evidence over the years, It's when the dollar is falling for a long period of time that these hedge ratios become very, very high. So a good example is the period before the GFC when the dollar was really falling quite considerably. But then what happened at the GFC was, of course, the dollar really spiked because there was a scramble for dollars.

27:46So there's always this trade-off. you either have to bear some currency risk or you bear this maturity risk and then bear this maturity mismatch risk, I should say. And so it's really a change in one type of risk or another.

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