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US dollar may benefit from month-end FX rebalancing

The USD is likely to strengthen against most currencies as investors who have hedged in the FX market reduce their foreign currency positions after losses in global equity markets.

The broad-based fall in equity market value was the largest since 2008, according to a recent report from Barclays Capital. As a result, index-based portfolio managers, who seek to keep their FX hedge notionals in line with the overall value of their portfolios, have been left over-hedged.

 Monthly change in equity and bond market value
 Source: Barclays Capital

Among the worst performers was the S&P500, which lost 6.6% in August. Analysts at Royal Bank of Canada say the fall is well over the 3% tolerance for hedging models to trigger a strong FX trade signal, so a strong unwinding of USD hedges is very likely to ensue.

RBC suggests an equally weighted basket, consisting of USD against AUD, CAD, NOK and SEK as the most efficient way to benefit from month-end hedging activity.

Meanwhile, analysts at Citigroup say their model is generating the strongest signal to sell EURUSD as European investors are expected to be buyers of USD to bring their hedges into line with lower US equity values. The Citi model is also issuing a weaker signal to sell USDJPY as both foreign and Japanese investors are expected to be net buyers of yen as they reduce hedges on Japanese equities and increase hedges on foreign bonds.

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