For over a century, the US dollar has dominated the financial world. Shortly after World War I, the dollar dethroned the mighty British pound, and many nations experiencing a financial resource crunch turned to the US for funds, which only served to boost American trade, economy, and global influence. Ever since, the dollar’s hegemony has rested on the country’s political, economic, and military power, manifested through market forces. However, between November 2022 and January 2023, the nominal broad dollar index fell almost 7%. This and the recent global turmoil caused by the Russia-Ukraine war, rising inflation rates, and the collapse of major banks among other factors, have generated much speculation on the possibility of a weaker USD with a declining hegemony.
War, rising inflation, collapsing banks, and other factors impacting the US dollar
In response to Russia’s invasion of Ukraine, the U.S. imposed economic sanctions on the country, which sought to weaken its currency, the rouble. Such sanctions prevented Russia from bringing back home the US dollars earned through its exports, which meant a shortage of dollars that astronomically propelled the price of the dollar against the rouble. As a result, Russia would only sell oil against rouble payments. The slightly lower volume of Russian oil exports led to speculative activity to increase the dollar price of oil in the market. These two developments ultimately led to an unintended outcome: the decline of the value of the dollar against the rouble.
Another consequence of the economic sanctions has been the revival of bilateral payments between Russia and other countries. In these trades, the dollar does not enter as a transaction medium, effectively eliminating the demand for dollars as a reserve currency. Most recently, China and Brazil followed a similar example, striking a deal to trade with their own currencies, ditching the US dollar as an intermediary and further threatening the dollar’s hegemony.
Also in the international sphere, recent developments have sparked worries about the relationship between the U.S. and a long-time ally: Israel. Dating back to Israel’s founding years, this special relationship has been firmly rooted in shared interests and values. In addition, both nations share a strong economic and commercial link, which is anchored by a yearly bilateral trade of approximately 50 billion USD in goods and services. Yet, the new Israeli government led by Prime Minister Benjamin Netanyahu could weaken the relationships as fears of an authoritarian transformation of the nation's democratic system loom.
At home, the North American nation has also seen signs of struggle. In early March, with the collapse of the Silicon Valley Bank (the nation’s 16th largest bank) and Signature Bank, the USD hit a record low. In early April, the US dollar continued to stumble as data revealed that the American economy kept slowing down by reducing spending in manufacturing and construction. The inflation and interest rates, while slowly receding, also have an impact on the USD’s value.
The forecasts on the future of the USD
Will a strong dollar return? And will dollar hegemony cease? J.P. Morgan research has speculated that the USD will continue to weaken in 2023 as its “significant overvaluation” can no longer be supported. The firm also acknowledges that there might be a “safe-haven” demand for USD in the scenario that the American economy goes into a deep recession. Overall, researchers forecast a modest dollar strength.
The forecast from a senior consultant at Euromonitor International also states that the dollar will further decline in 2023 and that its exchange rate volatility will remain high given various factors such as the ongoing global recession risk, US inflation, and macroeconomic uncertainty. Such developments might also “renew investor demand for US assets”, boosting dollar strength.
Other predictions have been less optimistic, speculating that, amidst global turmoil, the demand for US dollars will inevitably continue declining. In such a scenario, central banks might begin holding higher reserves of gold as it is the only physical asset that is universally accepted.
FX Hedging: a strategy to deal with uncertainty
To protect their position in a currency pair, let’s say the USD and GBP, from an adverse move, a trader might turn to forex hedging. In the finance world, hedging is a risk management strategy to protect investments and offset losses. To hedge, an individual invests in two different instruments with adverse correlation.
Think of it as a type of insurance. Someone who purchases a new house might also purchase homeowner’s insurance, which safeguards or hedges the property from damages arising from fires or unforeseen disasters. While hedging won’t prevent investment from experiencing losses, it does reduce the negative impact to a certain extent. Nowadays, hedging is used in several areas, including the commodities and security market, interest rates, and, of course, currencies, which are typically associated with risk and volatility.
While comparing hedging to some sort of insurance is helpful, in the financial market, this strategy is not as simple as purchasing a yearly policy for safeguarding investments. Hedging against investment risks entails using financial tools or market strategies in a strategic manner to offset the potential risk of adverse price movements.
There are several types of strategic FX hedging tools out there. A forward trade, for example, is an agreement between a company and a third party (a broker or bank) to exchange currency at a set exchange rate at a future date. Forwards trading allows businesses to conduct transactions with delayed payment without being impacted by exchange rate changes. Option trading is similar to forward trading, but it offers a higher degree of flexibility as there is no obligation to complete a transaction.
Who is FX hedging for?
FX hedging can be a highly effective approach for both individuals and businesses to safeguard themselves against adverse movements in currency rates when they anticipate the need to make a currency transaction at a particular point in time or even on a recurring basis.
Hedging is especially beneficial for companies that regularly purchase goods or services overseas rather than those buying on an ad-hoc basis. A business can opt to hedge once it has finalized an order to purchase goods or services and needs to lower the FX risk of such a transaction.
But what about private individuals? Certain people who aren’t necessarily involved in trading might need to carry out large transactions in foreign currency. So is the case for those who plan on moving permanently or for a long period of time overseas or those entitled to receive an inheritance from abroad. In these scenarios, hedging tools can lower the potential of FX risk and volatility.
Getting started on currency hedging
Getting into currency hedging might be confusing and overwhelming given the many strategies out there. A good starting point is using the hedging tool calculator by MoneyTransferComparison.com. The calculator works out how much someone might need to back or lay for a guaranteed profit or loss reduction on a betting exchange by trading out the market, which results in an equal profit or loss across all the sections of a specific market like currency exchange.