De-dollarisation — Threat or opportunity? 

Trade tensions, particularly with traditional allies, and unpredictable policy reversals have undermined confidence in US institutions. This has led to a sentiment shift among some asset managers and international investors, who are increasingly discussing reducing exposure to the USD.

The US faces growing national debt, with budget proposals indicating rapid debt growth and a need for external financing. The loss of the last triple-A credit rating and trade policies targeting countries that historically financed US debt is adding to concerns.

Despite these challenges, key market indicators such as tight corporate bond spreads and record equity highs still support USD assets, suggesting no mass exit yet. However, the DXY Dollar Index has fallen below its 200-day moving average to levels not seen in two decades, indicating a significant downdraft.

^{Source: Bloomberg}

Central banks and investors are actively exploring alternatives to the USD and US treasuries as low-risk assets, reflecting a cautious stance on the USD’s safe haven status.

While the USD’s dominance persists, these structural and sentiment shifts suggest a gradual erosion of its exceptionalism as the world’s reserve currency.

Currency exposure plays a critical role in strategic asset allocation, particularly as a risk mitigator.

Companies and investors use the USD as a base currency for hedging against foreign exchange risk through instruments like forwards, options, and swaps. This seeks to reduce volatility from currency fluctuations.

In our view, the Australian dollar (AUD) presents the largest opportunity for DAA currency positioning, with return differentials between hedged and unhedged international equities showing significant variation. For example, the AUD has a maximum 3-year annualised return differential of 21.3%, far exceeding other major currencies like the USD (5.8%) and Yen (16.3%):

During periods of equity market weakness, exposure to certain currencies like the USD and Yen has historically provided protection for Australian investors by reducing portfolio volatility. Keeping international equities unhedged during such times has also been shown to reduce growth fund volatility.

^{Source: Refinitiv, Mercer. Data as of March 31, 2025.}

Given the potential loss of the USD’s safe haven status, investors may want to reconsider their currency hedging strategies, balancing overseas currency exposure to optimise risk-adjusted returns.

The AUD has evolved as a significant currency in global reserves and international payments. The USD’s share of foreign exchange reserves peaked at 72% in 2001, but has since declined as reserve managers diversified into currencies like the AUD and Canadian dollar. Despite this, the USD remains dominant at levels comparable to 1995.

^{Source: Refinitiv, Mercer. Data as of March 31, 2025.}

The USD accounts for about 50% of international payments, rising to 60% when including intra-Euro area payments, underscoring its entrenched role in global trade. Historically, during equity market downturns, the USD and Yen have provided the most protection for Australian investors, highlighting the AUD’s sensitivity to global currency dynamics. The AUD exhibits notable volatility in currency pairs, which can be leveraged in DAA strategies to enhance returns.

^{Source: Refinitiv, Mercer. Data as of March 31, 2025.}

Equity market returns are influenced by two key drivers:

Equity performance: The fundamental returns from the underlying companies and sectors.

Currency performance: Fluctuations in exchange rates can impact the home currency value of international equity investments.

For Australian investors, currency movements can either amplify or dampen equity returns. For example, a weakening AUD can enhance returns on unhedged foreign equities when converted back to AUD, while a strengthening AUD can reduce them.

Our data^[i] shows that the return differentials between hedged and unhedged international equities are substantial, with the AUD offering the largest opportunity for active currency positioning. This dual driver effect can necessitate careful currency risk management and DAA to optimise portfolio outcomes.

Gold has historically been a store of value and a hedge against currency depreciation. It has seen a strong rally recently, benefiting from a shift in demand away from the USD. Approximately 70% of gold demand comes from jewellery and investment, with a significant share held in official reserves.

^{Source: IMF International Financial Statistics Note: The share of gold in official reserves is the gold reserves at market value as a percent of total reserves.}

Despite its appeal, gold’s potential as a reserve currency is limited by liquidity constraints and market size. It is not a medium of exchange or unit of account, which are critical reserve currency functions.

Cryptocurrencies like Bitcoin have gained mainstream acceptance, with increasing institutional adoption and the availability of ETFs, futures, and options facilitating trading. Bitcoin’s finite supply, borderless nature, and neutrality in transactions can be attractive features. Since 2020, Bitcoin has shown a positive correlation with equities, integrating into portfolios as a beta extension of equity exposure:

^{Source: Morningstar. CMBI Bitcoin Index and CMBI Ethereum Index is measured against Morningstar US Market Index.} 

However, Bitcoin’s high volatility (3-5 times that of equities) can amplify portfolio risk. It is not widely used as a medium of exchange or unit of account, and companies do not price goods in Bitcoin. Regulatory developments, especially around stablecoins, may influence demand but currently, Bitcoin does not meet key reserve currency criteria.

While gold and cryptocurrencies offer alternatives, each have significant limitations that prevent them from fully replacing the USD as the global reserve currency in the near term.

Investors are actively managing currency exposure to balance risk and return. Given the potential weakening of the USD’s safe haven status, investors are reassessing the level of overseas currency exposure in portfolios.

Many investors are adopting DAA strategies that exploit return differentials between hedged and unhedged positions, particularly focusing on the AUD’s significant return opportunities.

During periods of equity market weakness, investors have found that maintaining unhedged international equities can reduce portfolio volatility, leveraging currency movements as a natural hedge.

Investors are monitoring alternatives to the USD, including gold and cryptocurrencies, but remain cautious given the limitations and volatility associated with these assets.

We believe the AUD is poised to play an increasingly important role in DAA:

The AUD shows the highest maximum return differential (21.3% annualised over 3 years) between hedged and unhedged international equities, indicating significant potential for active currency management.

The AUD’s volatility can be harnessed to enhance portfolio returns through tactical currency exposure adjustments.

The AUD, alongside the USD and Yen, has historically provided protection during equity market downturns, making it a valuable component in risk mitigation strategies.

As global currency dynamics evolve with the potential weakening of the USD, the AUD’s role in portfolios is expected to grow, supported by data-driven currency hedging and allocation decisions.

2025 marks a pivotal year in currency strategy. The USD, while still dominant, faces structural and sentiment challenges that may erode its reserve currency status over time. We believe investors should look to adapt by revisiting currency hedging strategies, leveraging DAA opportunities, particularly with the AUD, and cautiously exploring alternatives like gold and cryptocurrencies. The integration of currency considerations into strategic asset allocation is likely to be key in managing risk and enhancing returns in an increasingly complex global financial landscape.

^{[i] Source: https://www.federalreserve.gov/econres/notes/feds-notes/the-international-role-of-the-u-s-dollar-2025-edition-20250718.html#fig1 International role of currency source: IMF World Economic Outlook database, Haver, Eurostat, Comtrade, IMF COFER; BIS Triennial Central Bank Survey of FX and OTC Derivatives Market; LSEG Data & Analytics; BIS locational banking statistics; Board staff calculations.}

^{Note: Share of global GDP is measured in nominal terms. Share of global trade is the share of global trade in goods and services in nominal terms and excludes intra euro-area trade. Index of international currency usage is a weighted average of each currency's share of globally disclosed FX reserves (25 percent weight), FX transaction volume (25 percent), foreign currency debt issuance (25 percent), foreign currency and international banking claims (12.5 percent), and foreign currency and international banking liabilities (12.5 percent). Key identifies in order from left to right. International payments source: IMF COFER. Share of globally disclosed foreign exchange reserves. Data are annual and extend from 1995 through 2024. Legend entries appear in graph order from top to bottom. Chinese renminbi is 0 until 2015-Q2. Share of international payments source: SWIFT, Bloomberg Finance LP. SWIFT (based on MT 103 and MT 202, customer initiated and institutional payments). Does include intra-euro area payments. Data are annual and extend from 2010 through 2024. Legend entries appear in graph order from top to bottom.}

^{[ii] Refinitiv, Mercer. Data as of March 31, 2025.}