We continue to believe US$-based investors should hedge a portion of non-US$ currency exposure, particularly that associated with tactical positions in non-US$ assets.* Strategic hedging to mitigate currency volatility may also be appropriate for investors with large allocations (e.g., 20%–25% or higher) to foreign currencies.** We maintain this recommendation even as we regard the US dollar as overbought, overvalued relative to a basket of other major developed markets currencies, and exposed to potential near-term consolidation.
We continue to recommend currency hedging for four reasons: (1) relative growth and monetary policy conditions are US$ supportive; (2) the US dollar tends to rise in periods of market stress; (3) history suggests this cycle may have more to run; and (4) hedging improves the risk/return profile of global equity investments. Today, the cost of hedging may be somewhat offset by the US dollar’s positive carry relative to many developed markets currencies.
US economic growth appears strong relative to other developed markets. Further, expectations that the US Federal Reserve will begin to raise rates later in the year are positive for the dollar at a time when the Bank of Japan and European Central Bank remain committed to weakening their currencies and many central banks are easing policy.
Of course, there is a risk that economic growth will not strengthen to the degree the Fed is expecting, particularly as a strong dollar itself is a drag on economic growth. If the disappointment is severe and results in a broader risk-off environment, the US dollar may counter-intuitively rally, as it tends to do amid periods when global risk aversion rises sharply. By reducing US equity allocations investors may decrease valuation risk, but are also increasing currency risk, which could accentuate underperformance in a down market for risky assets. Currency hedging allows reduction of valuation risk while maintaining neutral currency allocations.
It is unclear how much longer or to what magnitude the US dollar will appreciate. Relative to the two up-cycles since 1970, however, the current cycle appears to be 40%–70% complete in terms of magnitude and about 50% complete in terms of duration. In terms of valuation, the US dollar in real (inflation-adjusted) terms is roughly 14% above its long-term median, which we considered overvalued. In previous cycles, valuations peaked at 35%–45%.
The US dollar’s role in global finance has contributed to these extended cycles. When the US dollar rallies sharply, it puts pressure on US$ borrowers, who rush to pay down dollar debts or seek additional US$ liquidity/savings. The result is a self-reinforcing cycle that further elevates the dollar. This is most prevalent in emerging economies that are reliant on external, largely US$-denominated financing.
A case can also be made for more strategic currency hedging to improve the risk/return profile of global equity investments. Currency exposure can introduce a meaningful amount of volatility to portfolios relative to base currencies. As recent market action suggests, currency volatility has increased. Volatility may remain elevated in a low interest rate environment, given that central banks—having pushed to and through the so-called zero bound on policy rates—are increasingly using currencies as a key policy lever. As succinctly stated by Bridgewater Associates:
With central banks keeping the major reserve currency rates near zero for the foreseeable future, interest rates cannot discount future exchange rate changes, so spot currency moves are the only way to resolve such imbalances. In other words, in this environment, differences in external conditions and monetary policies will need to be resolved through larger shifts in exchange rates.
The US dollar has had a strong run and is now overvalued and vulnerable. Even as a period of consolidation may be in order, the dollar probably has more upside. We see no reason to underweight the US dollar, although we do see cause to underweight US equities. Currency hedging tactical equity positions allows US$-based investors to maintain neutral currency exposures. Further, some strategic currency hedging can reduce portfolio volatility, increasing risk-adjusted returns, and may prove somewhat defensive in a broader risk-off environment.
* We expect the US dollar to continue to appreciate against some emerging markets currencies as well. However, the cost of hedging emerging markets currencies and the negative interest rate carry make this less desirable.
** Typically, investors with such programs hedge roughly 50% of foreign currency exposure. Because currency moves can be significant, maintaining such a program requires use of currency-hedged benchmarks for performance evaluation. Without these benchmarks, it would be too difficult for most investors to tolerate relative performance swings given currency volatility can be high.
Celia Dallas is Cambridge Associates’ Chief Investment Strategist.