G10 FX Strategy: How Much Will FX Hedging Flows Boost EUR/USD?

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G10 FX Strategy: How Much Will FX Hedging Flows Boost EUR/USD?

IdeaM• Volatility, in both asset and currency

• Directional view on the currency

To this end, hedge ratios are most likely to rise when costs are low, volatility is high, and

investors are more concerned about currency weakness.

To estimate the magnitudes, we ran a multivariate regression on these three factors – 3m

EUR-USD hedging costs, FX volatility (FXVIX Index), and our USD positioning score

(MSOPDXY Index) against the aggregated USD hedge ratio implied by the Danish Central

Bank data for asset managers and insurers in Denmark. We believe these data are

sufficiently reflective of broader European trends based on our conversations.

The sensitivities are found below, with a regression adjusted-R^2 of 0.42 and p-values for

each beta well below 0.01:

• A 100bp reduction in EUR-USD 3m hedging costs raises hedge ratios +2.7pp

• A 10 percentage point reduction in USD positioning raises hedge ratios +0.6pp

• A 1 unit increase in the FXVIX Index raises hedge ratios +1.3pp

There is capacity for all three factors to positively contribute to hedge ratios.

First, FX vol is in the 11th percentile, having fully retraced YTD increases amid the bid to

risk assets ( Exhibit 3 ). Given our positive view on risk appetite, we're skeptical that FX vol

is likely to meaningfully rise, but with the 5y average of 8.5 vols (40th percentile) versus

6.8 vols, we think risks favor a higher, not lower figure. A return to 5y average levels of

FX vol implies a +2.1pp increase in hedge ratios.

Exhibit 3: FX volatility is currently in the 11th Exhibit 4: We estimate the market is relatively

percentile, well below the 5y average lightly positioned on the USD, thus there is ample

capacity for bearish USD positioning to ramp up