Capital Markets Update #7

Discussions around dollar debasement are not a new phenomenon.  Rhetorically probing risks to US reserve currency status creates clicks and therefore economics for all sorts of media outlets.  But, we get it, the discussion is interesting, so we’ll join the fray.  For reference, if there ever was a data source well suited to expound on this topic, it would be the Bank of International Settlements (BIS).  Pretty much everything in here is derived from their data and analysis. 

Currency markets are extraordinarily dynamic in that they can be moved by a range of both fundamental and technical shocks.  For instance, the dollar debasement trade would represent a fundamental shock to the US currency market if it actually was to occur – which it isn’t.  In this instance, the market would sell dollars today because it sees less value in dollar-denominated assets (US cash, debt or equity) in the future.  Alternatively, technical shocks can rattle a market, as well.  One example of a technical shock could be a market-wide recalibration of forex hedging positions.  The whiplash associated with an immediate unwind of excessive risk, which describes the covering of a systemically underhedged position within a currency market, can be very real and build to the point where the ubiquitous scramble for protection can produce material price volatility.  Just look at short covering or margin unwinds in various stocks or indices, as a reference.   

Lets first de-bunk the dollar debasement trade.  You can conveniently define “dollar debasement” as a market-wide rush out of dollar-denominated assets for fundamental reasons.  Dollar debasement would likely be exemplified by a drop in dollar price, less liquidity in US sovereign debt markets, meaningfully higher long-term rates and lower US asset prices.  Other than the dollar price one, none of that is happening.  According to the BIS, daily FX trade in dollars represented approximately 12x global GDP in 1992 and has since increased to approximately 30x global GDP in 2025.  Total FX trades in dollars increased 27% from 2022 to 2025 while M2 money supply of dollars grew a mere 3.3% over the same period.  Separately, the trailing 6-month average bid-to-cover ratio for new-issue 10-year Treasuries has increased from 2.20x in Q4 2019 to 2.50x in Q1 2024 to 2.55x today (MicroMacro data).  As of Q3 2025, 58% of global foreign exchange reserves are held in dollars compared to 20% in the Euro and 2% in the Chinese renminbi (Fed data).  Current foreign reserve dollar holdings of 58% is down from about 62% in 2006, nearly flat to 2014 and down from about 61% in 2019.  It’s not ironic that this number moves around a bit cyclically, albeit within a relatively tight range.  If you’re curious, Euro share of ForEX reserves is down from a high of 28% in 2008 to 20% today.  This is all representative of a deep, liquid and strong dollar market, by any standard.  Critics will argue this data is all backward looking.  Those same critics have made this same argument for the last 20 years and have never been right, so we don’t trust their analysis now. 

In reality, what happened in 2025 was a market caught offsides by a massive April 2025 “Liberation Day” tariff shock.  Currency markets are generally relatively stable (by comparison to their debt and equity peers), partially by design.  Small moves in trillion-dollar currency portfolios can have multi-billion-dollar implications.  In real, cold hard cash, you can lose a ton of money with a 0.5% move in a currency.  Accordingly, money managers generally hedge the heck out of their positions to manage these idiosyncratic volatility events.  As one currency goes down, the other goes up and it’s roughly a wash by design.

Leading up to 2025, the global ForEx market was significantly underhedged across its US dollar exposure.  There are a few reasons for this, notably the precipitous rise in dollar hedging costs from 2020 – 2025, the precipitous decline in dollar FX swap and derivative issuance, and the increasing premium paid for US dollar swaps in the market.  These are all obviously related and reflect the same market impulse across three separate datapoints.  It may be helpful to roughly define hedging costs.  ForEx hedging costs can generally be perceived as the cost differential in short term yields between two countries of similar credit quality. For instance, if I can hold dollars at 4% Fed funds rate and you want to give me Euros at 2% ECB rate, you owe me 2% plus a credit charge (which basically pays for the credit risk differential across the two currencies over the risk period).  In January 2022, Euro and US central banks commenced their hiking regimes, following a decade of low interest rate policy.  The consistent view in the market was the Fed would be more hawkish (keep rates higher for longer) than the ECB.  This was codified by a roughly 1% - 2% delta between ECB and Fed Funds rates from 2022 – 2025 throughout the hiking regime. The referenced hedge premium rate, calculated by BIS, for USD hedges against a basket of currencies (including the Euro) remained steady at about 2.50% - 3.00% from 2022 – 2025.  It was probably closer to the 2% range for a USD/Euro 3-month derivative, would be my guess.  So if you owned dollars and wanted to hedge that risk, it was expensive to do so.  Therefore, short term dollar lending (3-month dollar hedges) volumes decreased meaningfully to the tune of $1.2T issued in Q2 2021 down to a low of $600B issued in Q4 2024, according to the BIS.      

To level set around market sentiment leading up to January 2025, ForEx investors perceived the dollar market as incredibly expensive to hedge but undoubtedly desirable to own.  For instance, the DXY appreciated from 96 in 2022 to 109 by YE 2024 – a 4.3% average annual return. That’s big for currencies.  Using the midpoint of the BIS hedge premium curve, investors would dilute those 4.3% returns by engendering +-2.75% loss through hedging, netting a significantly less interesting 1.50% average annual yield.  The market decided that was less exciting, so the markets ran it hot without hedging.  Investors captured yield arbitrage between Fed Funds rates vs domestic yields by owning dollars vs something else, while also benefitting from basis appreciation (dollar price moving up as exemplified by DXY appreciation).  This all worked, until it didn’t.  Liberation day and its preceding events brought consternation to the dollar outlook and traders rushed to cover their unhedged positions, often pledging dollars as collateral for other currency exposure. This negative demand for the dollar drove down the value of the dollar (without a significant loss of liquidity in the actual dollar market) and conversely drove up the value of other foreign currencies.

One year later, we’re nearly back to where we started.  The DXY presently sits at 96.2, a level last seen in October 2021 (right before rate hikes) and consistent with levels traded throughout the 2015 – 2019 period.   Dollar utilization globally is exceptionally strong and demand for nearly all US risk assets is high.  But dollar price has adjusted and resettled; now you know the main reason why.