USD: A small piece of a large puzzle - Commerzbank

The US Dollar (USD) is set to continue weakening in the coming months. However, what is particularly interesting are the explanations other analysts offer for their respective forecasts. Recently, one argument has surfaced repeatedly: the increasing demand for hedging against USD weakness. This argument often points to the traditionally low hedge ratios in equity investments, Commerzbank's Head of FX and Commodity Research Thu Lan Nguyen notes.

Consensus might shift toward a weaker USD

"So far, the dollar exchange rate has been favorable for this type of investment, as a stronger equity market was often associated with more positive economic prospects and consequently a stronger currency. Therefore, hedging against exchange rate risks was generally considered unnecessary. The Bank for International Settlements (BIS), which published a paper on the role of increased hedging activity as a driver of dollar depreciation in April, highlights another point: Hedging against the dollar had been relatively unattractive in recent years due to high hedge costs (i.e., high US interest rates)."

"Currently, however, there seems to be a dilemma: Many investors still want to remain invested in US equities (belief in US exceptionalism is alive and well!), but at the same time, they see growing risks for the US dollar, not least due to the US government's attacks on the Federal Reserve. A significant depreciation of the dollar could reduce the returns on the actual equity investment or even wipe them out entirely. So what is the solution? Hedging against dollar weakness. Ultimately, these hedges are effectively bets on a weaker US currency and, if widely adopted, create selling pressure on the dollar."

"Exchange rates are determined by the consensus among market participants. Anyone selling dollars will need to find a buyer. A transaction only occurs when both sides agree on a specific exchange rate - in this case, a weaker dollar. If all other market participants share the same view, the dollar will depreciate. For this reason, the more important question is why the consensus might shift toward a weaker dollar. In my opinion, the US government's attacks on the Federal Reserve, which will likely push the central bank toward a more markedly expansionary monetary policy than it would have otherwise pursued, is a strong argument for such a shift in consensus."