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Hedging Could Help Returns of U.S. Investors during Bull Run for U.S. Dollar, According to Mellon Capital

BNY Mellon Manager Sees Tapering Leading to Rising Currency

U.S.-based investors with international portfolios might consider the merits of hedging as the U.S. dollar appears to be entering a period of sustained strengthening, according to Mellon Capital Management, the San Francisco-based multi-asset-class investor for BNY Mellon.

"A long bullish run by the U.S. dollar could detract significantly from the returns of international portfolios that are not hedged against the currency," said Sam Valtenbergs, senior quantitative/research analyst of Mellon Capital and the author of the white paper, Dollar Longs Buoyed by the Inevitable Taper.

Investors in exchange-traded funds (ETFs) might be surprised at the differences in returns from two separate ETFs, if one is hedged and the other is not, Valtenbergs said.

Since the beginning of May, the market has been focusing on the expected winding down of the U.S. Federal Reserve's quantitative easing program, according to the report. Over that period, the dollar has been strengthening against its developed market peers. In addition, the paper notes that emerging markets rates and currencies have had increased volatility.

Investors had been expecting the combination of the U.S. trade and budget deficits to continue to put downward pressure on the value of the U.S. dollar, but the budget sequestration that became effective on March 1 has helped to rein in the U.S. budget deficit, Mellon Capital said.

While the current account remains in negative territory, it has been stable for years, the report said. If the current account and budget deficits demonstrate continuing improvement, Mellon Capital said the dollar could continue to strengthen.

Mellon Capital's report said that the dollar is likely to outperform during periods of risk aversion and underperform during periods of heightened risk appetite. However, the currency could outperform over the longer term if the U.S. economy can continue to strengthen in a benign inflation environment, the report said.

"When one considers the relative inexpensiveness of hedging the currency risk of international portfolios against a rise in the U.S. dollar, it could prove to be good value for U.S.-based investors," said Vassilis Dagioglu, head of asset allocation, portfolio management, Mellon Capital.