Is the US Dollar still a cheap tail risk hedge?
1. What do we mean by tail risk?
"Tail risk" is an amorphous term and can mean different things to different investors. When thinking about tail risk hedging it is therefore important to define what tail risk protection is being sought against and so understanding the specific nature of the tail risk should be preface any further discussion on hedging tail risk. Tail risk in this context refers to adverse changes in the current market value of a global portfolio financial assets which causes their values to become and potentially remain depressed for a period of time. The tail risk typically manifests through a fall in the value of public market assets with a muted flow through to private market asset due to valuation lags
2. What do we mean by hedging tail risk?
A precise or accurate tail risk hedge is generally known to be expensive. For example, buying a put option to protect against a (say) 10% fall in the value of the FTSE100 is often sufficiently costly that buying and holding (rolling) the hedge for a long period of time can erode most of the rewards from being invested in the FTSE100.
Proxy hedges are considered cheaper than precise hedges. Proxy hedges are assets whose values are expected in most circumstances to be inversely related to the asset for which protection is sought.
For example, assume a UK investor investing £100 equally split between the FTSE100 and S&P500. The investor is most concerned with protecting their investment in Pound terms. Despite this, our investor chooses not to hedge the currency risk from buying the S&P500 but instead accepts that if the US Dollar (USD) falls in value against the British Pound (GBP) then the investor will make a loss in GBP terms, all else being equal. One possible reason for taking this risk of Cable depreciation ("Cable" is a commonly used acronym for the Pound/Dollar exchange rate) depreciation is that the investment portfolio retains exposure to the US Dollar as a proxy tail risk hedge against adverse outcomes.
3. Why is the USD considered to be a proxy tail risk hedge?
Historically, when the outlook for the global economy is either very good or very bad then the US Dollar has tended to appreciate against other currencies but has a tendency to tread water when the global outlook is meh. This is often referred to as the "Dollar Smile"; a term apparently coined years ago by Morgan Stanley foreign exchange (FX) strategists, the 'dollar smile' theory argues that USD does best when things are either very good (arguably driven by US growth) or very bad (safe-haven demand).
The chart below shows this:
4. Will the Dollar still smile?
The USD has shown significant strength against most G10 crosses due to 1) relatively high US rates linked to 2) the strong outlook for US growth and potential inflationary consequences driven partly by so-called US exceptionalism.
In the event of a global recession, will the Dollar (at least) initially outperform other currencies and so provide the tail risk hedge shown in the chart above?
There are a few reasons to think that this time could be different
a) At the present time interest rate differentials between the US and other countries is relatively high. This means that a US investor investing in global equities (ex US) probably hedges any FX exposure back into USD to avoid paying away the high yield on his or her US dollars or because they don’t have a view on the offshore currency vs the USD. In the event of a global recession, if these investors view the "risk aversion" trade as unwinding offshore equity holdings and repatriating this to the US, they would also be unwinding the currency hedge and so there is no net positive impact on the value of the USD from this repatriation trade.
=> Net impact = neutral for USD
b) That said, US investor positioning is currently skewed to US equities (including the Mag 7) at the expense of global equities (ex US).
A global recession and US equity sell-off may, if coupled with the Fed cuts lowering yields on US bonds, prompt some of these US investors to consider that rebalancing out of US equities into global equities on an unhedged basis is a risk-reducing trade. [Falling US rates reduces the negative carry from being invested in non-USD denominated equities and so reduces the potential opportunity cost of not hedging the currency risk]
=> Net impact = negative for USD
c) If the US is cutting rates in response to recession fears then this reduces the interest rate differential to other currencies making it more attractive for foreign investors in US equities to hedge their USD risk back to their home currency.
=> Net impact = negative for the USD.
d) Unlike in previous times of market stress when foreign central banks experienced a shortage of US Dollars, swap lines agreed between these central banks and the Fed means that the USD supply/demand imbalance which held up the Dollar will not have the same impact in the future.
=> Net impact = neutral for the USD
Taking it all together there are good reasons to believe that in a global recession scenario the USD may not provide the tail risk hedge it once did.
