The proportion of currency hedging applied by major global institutional investors to their US dollar assets has dropped to the lowest level ever recorded.

According to data compiled by Bloomberg from six markets, as of June 30 this year, pension funds and insurance companies in key markets such as Japan and Canada had hedged only about 41% of their dollar exposure, the lowest since records began in 2015. This indicates that the surge in currency hedging demand triggered earlier by Trump's tariff shocks has clearly receded, with institutions reverting to the low-hedging strategies that have prevailed over the past decade.

However, with the dollar weakening, hedging costs declining, and confidence in the dollar's safe-haven status being challenged, this strategy may be on the verge of reversal. Should institutions increase their hedging ratios once again, the vast unhedged dollar exposure could transform into new selling pressure on the greenback.

Bloomberg estimates that if global institutional investors raised their hedging ratios by just 5 percentage points, based on the combined foreign currency holdings of approximately $4.6 trillion across six markets, it could correspond to roughly $230 billion in dollar selling. In the vast foreign exchange market, this potential capital flow cannot be ignored.

Hedging Costs Drop, Institutions Reassess Currency Risk

In recent years, institutions have consistently lowered their currency hedging ratios for dollar assets, largely due to prohibitive hedging costs. But this constraint is now easing significantly. The three-month dollar hedging cost in yen terms has fallen from a high of 6% in October 2023 to 2.75% now, the lowest in four years; for euro-based investors, the cost of hedging dollars has also declined to 1.32%, hitting a two-year low.

The reduction in hedging costs means the barrier for institutions to re-establish currency protection is lowering. Laura Cooper, head of global macro credit at Nuveen, noted that given the scale of foreign investor holdings of US assets, even a small shift in hedging ratios could generate substantial currency flows.

Nathan Thooft, chief investment officer of the multi-asset solutions team at Manulife Investment Management, believes that if the market continues to lower expectations for Federal Reserve rate hikes and interest rate differentials narrow further, investors may begin re-establishing hedge positions, thereby creating sustained dollar selling pressure.

In other words, dollar hedging activity itself could act as an amplifier for the dollar's trajectory: in a low-hedging state, a dollar decline has a relatively limited impact on institutional balance sheets; but once institutions begin to concentrate their hedging increases, the capital flows selling dollars could further intensify the greenback's downturn.

The Dollar's 'Safe-Haven' Status Is Being Re-Evaluated

What warrants greater attention is that the driver for increased hedging may not just be cost changes, but also challenges to the dollar's safe-haven properties themselves. For a long time, the dollar has tended to strengthen during periods of sharp global market volatility, which meant that overseas investors holding unhedged dollar assets could, to some extent, offset declines in other asset prices through dollar appreciation.

But this traditional logic is now being questioned. Factors such as US fiscal policy, long-term Treasury yields, and Japan-US exchange rate policy are leading the market to reassess US policymakers' tolerance for the dollar and interest rates. Meanwhile, discussions about the Federal Reserve's policy independence and the future path of interest rate differentials are also eroding the dollar's previously relatively stable safe-haven narrative.

Noureldeen AlHammoury, chief market strategist at Equiti Group, stated that if investor confidence diminishes in the dollar's ability to sustain appreciation during periods of market stress, then large-scale unhedged currency exposure will become increasingly difficult for institutions to accept.

However, increasing currency hedging does not necessarily mean institutions will simultaneously sell US stocks or Treasuries. Institutions can continue to hold US assets while selling dollars through currency forwards and other foreign exchange tools to reduce exchange rate risk exposure. This implies that even if the dollar faces pressure, demand for US assets themselves may remain relatively stable.

Stuart Simmons, head of multi-asset solutions at QIC, an Australian sovereign-backed asset manager, suggested that with geopolitical uncertainty continuously rising, investors need to rethink whether the dollar remains the primary vehicle for defensive assets in portfolios, and consider further diversification within foreign currency allocations.

Japanese Institutions May Be the Key Variable in a Hedging Shift

Among the potential shifts in hedging behavior, Japanese investors deserve particular attention. Japan is the largest foreign holder of US Treasuries, accounting for roughly 10% of total overseas holdings; Canada is also among the major foreign holders.

According to Deutsche Bank estimates, Japanese investors' currency hedging ratio for new overseas bond investments in the first half of this year was only 41%, down notably from 62% in 2024.

Shoki Omori, chief Japan fixed income strategist at Deutsche Bank, pointed out that the last time Japanese investors had such a low hedging ratio was in 2013. At that time, the dollar subsequently entered a decade-long period of strength, but the current macroeconomic environment presents a stark contrast to that era.

In Omori's view, three factors could drive Japanese institutions to increase hedging again: further rate hikes by the Bank of Japan and continued narrowing of Japan-US interest rate differentials; a significant dollar decline prompting institutions' risk committees to activate currency protection mechanisms; and the implementation of a new solvency regulatory framework for insurers, raising institutions' sensitivity to currency fluctuations.

However, Erik Nelson, strategist at Wells Fargo, believes that monetary policy will remain the core variable determining the dollar's medium-to-long-term trajectory, with institutional hedging behavior playing more of a short-term amplifier role rather than being a fundamental factor setting the dollar's direction.

But he also noted that as dollar hedging costs decline, the scope for investors to increase hedge positions is expanding. If the dollar were to weaken even as risk aversion rises, currency hedging behavior could shift rapidly and further accelerate the dollar's decline.