Hedging Appropriate as Dollar Strengthens

The San Francisco-based multi-asset-class investor for BNY Mellon said hedging could be something to make use of as the U.S. dollar appears to be entering a period of sustained strengthening. “A long bullish run by the U.S. dollar could detract significantly from the returns of international portfolios that are not hedged against the currency,” said Sam Valtenbergs, senior quantitative/research analyst of Mellon Capital and the author of the white paper, “Dollar Longs Buoyed by the Inevitable Taper.”

Investors in exchange-traded funds (ETFs) might be surprised at the differences in returns from two separate ETFs, if one is hedged and the other is not, Valtenbergs said.

Since the beginning of May, the market has been focusing on the expected winding down of the U.S. Federal Reserve’s quantitative easing program, according to the paper. Over that period, the dollar has been strengthening against its developed market peers. In addition, the paper notes that emerging markets rates and currencies have had increased volatility.

Investors had been expecting the combination of the U.S. trade and budget deficits to continue to put downward pressure on the value of the U.S. dollar, but the budget sequestration that became effective on March 1 has helped to rein in the U.S. budget deficit, according to Mellon Capital.

While the current account remains in negative territory, it has been stable for years, the paper said. If the current account and budget deficits demonstrate continuing improvement, Mellon Capital believes the dollar could continue to strengthen.

The white paper found that the dollar is likely to outperform during periods of risk aversion and underperform during periods of heightened risk appetite. However, the currency could outperform over the longer term if the U.S. economy can continue to strengthen in a benign inflation environment, the report said.

“When one considers the relative inexpensiveness of hedging the currency risk of international portfolios against a rise in the U.S. dollar, it could prove to be good value for U.S.-based investors,” said Vassilis Dagioglu, head of asset allocation, portfolio management, Mellon Capital, San Francisco, California.

When asked what specifically should defined benefit (DB) pension plan sponsors do and what will happen to DB portfolios that don’t hedge against the bull run for the dollar, Dagioglu told PLANSPONSOR, “U.S.-based DB plans with big international positions should consider hedging against a rising U.S. dollar, which is a trend that can continue for some time. It’s a relatively small cost to pay given that short-term interest rates and funding costs are very low across most developed currencies, but would offer significant protection.”

A copy of the paper can be found here.