Less costly, more compelling: Shifting FX hedging dynamics and US credit

September 2, 2025

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In his latest column on the key developments, themes and opportunities in credit markets, Ian Horn looks at the implications of a change in US dollar-euro hedging terms.

Currency hedging is a key consideration in relative-value analysis for currency-hedged investors. As yields and realised total returns can be dramatically impacted by currency hedging, expectations of how these will change must be factored into asset allocation decisions. We believe currency hedging costs will play a particularly important role over the next 12 months as monetary policy diverges and currency hedging costs evolve to reflect this.

Currency hedging costs (and benefits) are primarily driven by the anticipated difference in short-term rates in two different currencies over a specified period. For example, the 3-month hedging cost between US dollars and euros can be approximated by the expected difference between Federal Reserve and European Central Bank (ECB) policy rates over that timeframe. Since the Fed Funds Target Rate is currently significantly higher (4.50% - upper bound)¹ than the ECB Deposit Facility Rate (2.00%),² there is a cost to hedge USD exposure into EUR, and a benefit when hedging EUR exposure into USD.

In Figure 1, we plot the 3-month hedging cost between USD and EUR, and the spread between the local policy rates to show this relationship.

Policy divergence

The market is currently pricing in an end to the ECB’s rate-cutting cycle, with one more cut expected in March next year. Concurrently, an acceleration from the Fed is expected with five cuts anticipated over the next 12 months.³ This is the divergence in central bank policy we refer to above. Figure 2 replicates Figure 1, but adds the market’s expectation for the difference between these policy rates over the next 12 months, helping us to make an approximation of expected currency hedging costs.

Back in vogue?

For currency-hedged investors like us, the result is that an increasing portion of local USD yields will become available — after currency hedging — to drive returns. The cost of holding USD in a EUR portfolio will fall, which logically should make US credit more attractive, while the benefit of holding EUR in a USD portfolio will also decline, also making USD more attractive. Regardless of the base currency, we believe the appeal of USD credit is likely to rise for currency-hedged portfolios.

One could argue that as the Fed cuts rates, US Treasury yields will also fall, offsetting the benefit of lower hedging costs. However, as these cuts are already priced into rate curves, yields will likely only fall in the very short end of the curve, essentially driving a long-awaited normalisation of US rate curves (Figure 3).

This increased yield and return potential is one reason why we have started rotating into USD credit in our yield-focused, short-duration accounts. This aligns with other arguments for adding USD exposure, including the structural demand for USD credit that lower policy rates could bring, as I noted last month.

 

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