As U.S. equity markets have soared in recent months, the dollar has steadily declined against most of its major rivals, recently falling below the key $1.50 level against the euro for the first time since August of last year. This extended fall has investors wondering if the dollar’s decline reflects temporary volatility, or a long-term trend.
Despite the negative connotation, a less valuable currency may not be a negative development for the U.S. economy. But it has nevertheless become a concern for many investors who have begun to seek out ways to hedge against a further decline. Not surprisingly, there are a number of ETFs that offer a way to profit from a falling dollar. Today, we take a look at one of these options: exchange-traded commodity products.
Root of the “Problem”
Pinpointing causes for exchange rate movements can be tricky, but the major drivers of the dollar’s decline this year seem to be related to three key trends. The appearance of economic “green shoots” has been encouraging for investors anxious to officially close the book on the recent recession, and has spurred a new appetite for risk. Investors who flocked to the safety of U.S. Treasuries at the height of the global downturn are now putting their money into more risky assets such as international equities.
Second, record-low interest rates in the U.S. have provided little appeal for investors looking to play the carry trade or simply to generate an acceptable low-risk return. The Federal Reserve has kept its benchmark interest rate between zero and 0.25% for almost a year, offering little incentive to invest in Treasuries. Until recently, most other developed economies were in the same boat. But Australia and Norway have now begun raising rates, setting the stage for other countries that have distanced themselves from the recent recession to follow. In addition, many emerging markets still offer relatively high nominal rates of interest in money market accounts, making these currencies a better option.
Finally, it is possible that the dollar will lose its status as the world’s reserve currency. Over the last decade, the dollar has accounted for approximately two-thirds of total allocated foreign exchange reserves. If countries shift away from the dollar as a reserve currency, there could be significant impacts on both the value of the currency and the U.S. economy. If the dollar is replaced as the world’s reserve currency (some argue it will never happen), it certainly won’t occur overnight. But it is certainly a possibility (however remote) that is on the mind of investors around the world.
A falling dollar isn’t necessarily bad news. As the greenback slips, American-made products become less expensive to overseas consumers, making U.S. products more competitive in the global market place. For decades, China has relied on an artificially undervalued currency to drive overseas demands for cheap goods.
ETF Plays for a Falling U.S. Dollar
The development of the ETF industry has given investors access to countless asset classes and investment strategies that were previously restricted to sophisticated traders and large financial institutions. Investors looking to hedge against exchange rate movements or make a speculative currency play have historically relied on forex accounts, but there are now a number of exchange-traded products that allow efficient, inexpensive exposure to both direct and indirect currency investments.
Whether you’re a long-term investor looking to establish a hedge in your portfolio or a short-term trader aiming to profit from exchange rate movements, Over the next week, we’ll be taking an in depth look at various ETF options that have the potential to rise if the dollar continues to decline. Today, in part one of the series, we take a look at the use of exchange-traded commodity products as a hedge against a depreciating dollar.
Relationship with the Dollar
The strength of the relationship between the U.S. dollar and commodity prices is often debated, but the fact that there is some correlation between these assets is quite clear. Commodities such as gold, oil, and grains are generally priced in dollars (even outside of the U.S.). So all else being equal, a falling dollar makes commodities cheaper (in terms of local currency purchase price) around the world. This increases demand, which forces prices higher such that commodities maintain their value on the global stage.
The value of the U.S. dollar is certainly not the only factor that drives commodity prices. While some natural resources (such as gold) serve primarily as stores of value, the vast majority are used primarily in manufacturing and industrial operations. As manufacturing activity picks up, the prices of goods such as copper, lead, and zinc generally rise. Food commodities, including wheat, corn, soybeans, and livestock, can be impacted by supply shortages that arise from a variety of situations.
But the value of the dollar plays a major role in determining commodity prices. In 2009, the correlation between the value of the dollar and commodity prices has been strong and negative, an indication that the aforementioned pricing mechanism is playing out.
ETF Options Aplenty
For investors looking to gain exposure to commodity prices, there are a number of ways to do so through ETFs. Perhaps more than any other asset class, the rise of the ETF industry has democratized commodity investing, facilitating investments in natural resources for all levels of investors.
Exchange-traded commodity products track prices using a number of different strategies. Some physically buy and hold the underlying commodity, while others invest in futures contracts. For investors looking to invest in a particular commodity, there are dozens of options focusing exclusively on a particular good:
In addition to the numerous single commodity funds outlined above, there are a number of indexes that track a broad basket of commodities. These benchmarks include:
- DJ-UBS Total Return: Measures the collateralized returns from a basket of 19 commodity futures contracts representing the energy, precious metals, industrial metals, grains, softs and livestock sectors. ETFs tracking this index include DJP.
- CMCI Total Return: Measures the collateralized returns from a basket of 27 commodity futures contracts representing the energy, precious metals, industrial metals, agricultural and livestock sectors. ETFs tracking this index include UCI.
- S&P GSCI Total Return: A production-weighted index of the prices of a diversified basket of 24 futures contracts on physical commodities traded in major industrialized countries. ETFs tracking this index include GSP.
- Rogers Total Return: Designed by legendary investor Jim Rogers, this benchmark includes 36 commodities from 11 international exchanges. ETFs tracking this index include RJI.
- Deutsche Bank Lliquid Commodity Index: A rules-based index that invests in futures contracts on 14 on the most heavily-traded and important physical commodities. ETFs tracking this index include DBC.
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Commodity investing isn’t for everyone, and it comes with risk of significant short-term fluctuations. But for those looking to profit from or protect against a declining U.S. dollar, these ETFs offer diversified exposure to a number of different natural resources.
Disclosure: No positions at time of writing.