BNY’s Geoff Yu notes that the July FOMC-driven Dollar hedging impulse has largely run its course, with early signs of USD buying returning against EUR, MXN and CAD. Trade-weighted Dollar holdings are historically light, suggesting scope for stabilization, but a sustained recovery still depends on stronger U.S. asset demand and renewed real-rate leadership.

Dollar hedges unwind after FOMC

“Our flows are showing the first signs of dollar stabilization after a difficult August. After spending much of Q2 and Q3 significantly overheld as part of the “U.S. exceptionalism” trade, the dovish interpretation of the July FOMC meeting prompted a flurry of dollar hedging.”

“One day doesn’t signal a trend, but the past three weeks indicate there was no appetite to add aggressively to dollar hedges. The Fed’s signal that it’s willing to continue rate hikes removes the main driver for dollar sales in early August.”

“Overall USD holdings remain elevated, but without any re-opening of a policy gap between the U.S. and peers, we don’t see any additional constraints on dollar performance. Tariffs notwithstanding, stronger performance against the currencies of key U.S. trading partners also represents incremental tightening through pass-through.”

“We expect dollar holdings to stabilize around current levels now that Fed expectations have adjusted. There are idiosyncratic reasons for markets to avoid adding to MXN, CAD and EUR aggressively, while CNY’s impact is diminishing.”

“Shifting the dollar toward a case of holdings recovery requires strong asset interest and leadership in real rates. Qualitatively, this requires the Fed to shift toward restrictive policy – a stance that all but precludes asset performance, especially in equities.”