The dollar index slipped from an 18-month high as Treasury yields dropped. Foreign holders of U.S. assets have cut their currency hedges to below 15% from about 25% in April, which means a sharp equity selloff could turn into dollar selling.
A hot inflation week should be good for the dollar. Higher prices mean a tighter Fed, higher U.S. yields and a stronger case for holding dollars. This week the currency did not cooperate.
The dollar index, which measures the currency against six major peers, was near 101.85 in early Thursday afternoon trading, about 0.7% below Wednesday's close, with most of the drop coming overnight. Earlier this week it reached 102.95, its highest level in about 18 months. The euro was near $1.12 and the yen near 158.2 per dollar.
Rates first
The simplest explanation is rates. The 10-year Treasury yield fell about 10 basis points on Thursday from Wednesday's 5.19% close to near 5.09% in intraday trading despite a 1.3% jump in producer prices, extending a decline that began Wednesday after the consumer-price report. Expectations for a Fed increase this month eased, with CME FedWatch putting the odds near a third. Lower U.S. yields reduce the reward for holding dollars.
Swap markets price only about a 15% chance that the European Central Bank raises rates at its Oct. 29 meeting.
The hedging channel
There is a second mechanism, and it matters more if markets get rougher. Foreign investors who own U.S. stocks and bonds can protect themselves against a falling dollar by selling it forward. Many have stopped doing so. Hedge ratios on foreign holdings of U.S. assets are now "below 15%, compared with around 25% in April," said a strategist at State Street, who added that a major equity rout "could swing it around."
The logic is straightforward. An unhedged foreign investor holding U.S. stocks is exposed to both the stock price and the currency. If U.S. equities fall sharply, that investor can either sell the stocks or add currency hedges, and both actions mean selling dollars. Low hedge ratios leave more room for that kind of selling.
This week offered a preview. Technology stocks sold off hard in Asia on Thursday, the dollar did most of its falling overnight while Asian markets were trading, and it held those losses through the U.S. session.
Market implications
One reading is that this is ordinary rate arithmetic. U.S. yields fell more than those elsewhere, futures pricing for a Fed increase eased, and the dollar moved with the yield gap. On that view, a stronger inflation print or a hawkish Fed would lift it again.
A second reading is that the dollar has started trading as a U.S. risk asset. Foreign investors hold large, mostly unhedged positions, the AI-linked selloff is testing those positions, and the currency weakened during a week of hot data rather than strengthening. If that is right, the dollar becomes less of a haven precisely when U.S. stocks fall.
What to watch
Whether the dollar falls further on days when U.S. stocks drop, even as yields rise, would be the clearest sign that the hedging channel is at work. Fed Chair Kevin Warsh's remarks Thursday night and the ECB's Oct. 29 decision will set the rate side of the ledger.