Continuing from Part 1 where we concluded that the costs of hedging will almost certainly outweigh the benefits, we now look into detail as to the return drivers of the hedge, and why they amount to nothing.
Currency hedging typically works well when the foreign currency is negatively correlated with the foreign asset, as this means that the currency hedge gains when the asset is falling and vice versa, with a net effect of reducing the volatility of the hedged portfolio.
In this case, the Pearson correlation between the returns of SPX and the hedge (short USDSGD) is +0.235 (slightly positive), and so that does not help in reducing volatility.
From the scatter plot we can see that the returns are rather evenly clustered around the origin. The R-squared value for the linear regression is a mere 0.055 - suggesting that linear relationship of the two returns are very weak.
Taking a look at rolling correlations, the monthly returns of SGD (short USDSGD a.k.a. the hedge) have been more positive than in earlier periods (1990s and ~2005).
Notably, the 2008 crisis caused the SGD to be rather highly correlated to the SPX for several years. It has more recently subsided to the ranges of 0.30 but this is still positive and this means that leaving it unhedged actually provides some diversification benefits, as the USD strengthens (against SGD) when the S&P is not doing well, and vice versa.
Thus, in the short term, we don't expect to gain much from the hedge.
Fundamentals and regime shifts
Taking a longer-term perspective, it is unlikely that the SGD can repeat such a dramatic ascent from its levels of 2.0 USDSGD to present levels of 1.35, representing a 48% increase in value (SGD terms). This rise can be attributed to Singapore's rapid development which brought her into the ranks of developed countries, which is an unrepeatable event.
Thus, in the long term, we don't expect to gain much from the hedge either.
Altogether, it continues to argue for the case that we should leave the USD unhedged.