While USD Weakness Grabs Headlines, Our Interest Rates Factor May Reveal Deeper Insights

The weakening USD has made headlines thus far in 2025. Since mid-January, it's fallen
just shy of 11% against a basket of major currencies.¹ Since 1971, declines of this
magnitude or greater over a similar timeframe have occurred only 2.5% of the
time.² This has likely benefited U.S. investors with unhedged international exposure, as
their assets are held in non-USD currencies.

But here's what's surprising: our research shows that some assets’ volatility have
become less driven by our Foreign Currency factor, not more. By separating pure
currency movements from interest rate-driven effects, the Two Sigma Factor Lens
reveals how these factors can shift their roles as primary drivers of risk.

This piece highlights a practical example of how Foreign Currency and Interest Rates
factors can interact, while demonstrating a broader truth: fundamental drivers of risk
change with market conditions, even when asset class labels stay the same. We hope
to highlight how looking beyond headlines to monitor shifting factor relationships is
critical for effective portfolio management.

Setting the Stage: Why International Bonds Tell the Story

Let's begin by examining our Foreign Currency factor through unhedged international
government bonds and equities.³

Using Venn's Two Sigma Factor Lens in Exhibit 1, we find that our Foreign Currency
factor explains 6.87% of international equity volatility, but a dominant 40.90% for
international bonds. While this is just an analytical appetizer, the idea that a bond fund's
risk can be mostly driven by our Foreign Currency factor may be surprising to some
investors.

Exhibit 1: Venn’s Foreign Currency Factor Explains the Majority of Unhedged
International Bond Risk

Source: Venn by Two Sigma. The table includes Equity and Interest Rates (Tier 1 Macro Factors) and our Foreign Currency factor
only; percentages do not sum to 100% due to excluded factors.

Why does our Foreign Currency factor explain more risk for unhedged bonds than
equities? This is mainly due to the relatively lower volatility of bonds, which allows
currency risk to have greater relative impact.

This international bond fund is the perfect case study for what happens next. While our
Foreign Currency factor has historically dominated its risk profile, our Interest Rates
factor has always played a meaningful secondary role, but is this still true today?

The Big Shift: Interest Rates Become The Primary Driver of Risk

Here's where it gets interesting. Our trend analysis in Exhibit 2 tells a completely
different story than the static numbers in Exhibit 1.

Looking at our rolling 3-year factor analysis, the Foreign Currency factor peaked when
explaining roughly 70% of international bond risk around 2017–2019. It then reversed,
dropping to roughly 20% today. At the same time, our Interest Rates factor surged from
15% to nearly 50%.

Exhibit 2: Rolling 3-Year Factor Contribution to Risk for the iShares International
Treasury Bond ETF (IGOV)

Source: Venn by Two Sigma from 1/22/2009–6/19/2025. This chart only includes Interest Rates and Foreign Currency factors and
will not add up to 100%.

Put simply: In our example, while USD weakness makes headlines, the explanatory
power of our Foreign Currency factor actually declined meaningfully, while our Interest
Rates factor has been explaining more risk.

This demonstrates how fundamental drivers of risk can evolve as markets digest new
regimes around trade, inflation, and geopolitical developments. Whether investors have
direct international bond exposure, or diversified multi-asset portfolios, it may be time to
reassess their drivers of risk.

The Early Warning: Factor Models May See What Headlines Miss

Digging deeper into Exhibit 2, the changing trends between our Foreign Currency and
Interest Rates factors began as early as 2017–years before the latest inflation surges,
rate hiking cycles, or USD volatility.

This shows how factor models can capture subtle changes in correlations and relative
volatilities that may reveal fundamental shifts earlier than traditional analysis or
headlines. This early detection matters because by the time a risk regime changes,
portfolios may have already experienced significant unintended exposures.

Identifying these trends as early as 2017 demonstrates how factor decomposition can
find structural changes in market dynamics that otherwise might remain hidden.

The Bottom Line: Why This Matters for Your Portfolio

This isn't just a technical curiosity, this analysis has real portfolio implications.

USD weakness only tells part of the risk story. While currency moves capture attention,
our analysis reveals that our Interest Rates factor has quietly become the more
prominent driver of international bond risk, a shift that began taking place years before
recent market volatility.

This example illustrates a fundamental truth about modern markets: risk factor
relationships are not static.

What drove portfolio volatility in 2015 may not drive it today, even within the same asset
class.

For institutional investors, this suggests that ongoing factor analysis may be essential
for staying ahead of evolving market dynamics and identifying shifting trends earlier.
Whether managing international bonds or diversified multi-asset portfolios, investors
should reassess how their fundamental risk exposures have evolved, especially in
current markets.

References

¹Source: Bloomberg using the DXY Index. Period from 1/13/2025–6/25/2025.
²Source: Bloomberg. Using the DXY Index, 2.5% refers to the percentage of 118 trading-day rolling periods since 1971 that posted declines equal to or greater than the 1/13/2025–6/25/2025 period.
³International government bonds represented by the iShares International Treasury Bond ETF (IGOV) and international equities represented by the iShares MSCI ACWI ex US ETF (ACWX).

Exposure to risk factors is not a guarantee of increased performance or decreased risk. References to the Two Sigma Factor Lens and other Venn methodologies are qualified in their entirety by the applicable documentation on Venn.

This article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed. The views expressed above reflect those of the authors and are not necessarily the views of Two Sigma. This article (i) is only for informational and educational purposes, (ii) is not intended to provide, and should not be relied upon, for investment, accounting, legal or tax advice, and (iii) is not a recommendation as to any portfolio, allocation, strategy or investment. This article is not an offer to sell or the solicitation of an offer to buy any securities or other instruments. This article is current as of the date of issuance (or any earlier date as referenced herein) and is subject to change without notice. The analytics or other services available on Venn change frequently and the content of this article should be expected to become outdated and less accurate over time. Two Sigma has no obligation to update the article nor does Two Sigma make any express or implied warranties or representations as to its completeness or accuracy. This material uses some trademarks owned by entities other than Two Sigma purely for identification and comment as fair nominative use. That use does not imply any association with or endorsement of the other company by Two Sigma, or vice versa. See the end of the document for other important disclaimers and disclosures. Click here for other important disclaimers and disclosures.