Commentators rushed to call for the end of the dollar as a reserve currency for the first four months of the year. But three weeks into May and the US dollar looks headed for a revival in the face of mounting problems in Europe and Japan.
The key to the dollar’s revival may be found in the composition of the US Dollar Index giving investors a way to hedge global problems.
Looking closely at the US Dollar Index we find that the Index is comprised of just 6 currencies with the euro comprising a greater than 58.6% weighting, the Japanese yen second at a 12.6%, and the pound sterling third at an 11.9%. The final three currencies, the Canadian dollar, Swiss franc, and the Swedish krona comprise the remaining 16.9%.
The BRIC nations have no weighting in the index meaning that any depreciation by the US dollar against those currencies is invisible towards those following the indices.
Taking a closer look at the three main components of the index we find that there are significant problems with each country.
Japan is still recovering from the aftereffects of the disaster in March along with prolonged deflation and slow economic growth. Once the Fukushima plant has been stabilized reconstruction plans should begin in the fall. Already some manufacturing and smelting plants are coming back online with others expect to be back in the coming months.
Severely damaged areas will see the rebuilding process start later this year with demand for materials like concrete, steel, coking coal, and copper in high demand. This means significant outflows of capital from Japan in order to pay for materials. The Japanese Yen will begin depreciating in anticipation of increased spending on reconstruction projects.
Europe seems mired in problems with the PIIGS as Ireland faces continued problems after the bailout, Portugal moves into the bailout category, Spain limps along, and Greece seems headed for a standoff over a debt restructuring.
Talk is growing that Greece may pull out of the euro although it is unlikely to happen. The ultimate cost to leave would be too great and permanently damage the country. Voter angst over Germany’s bailout contributions offsets solid German economic growth.
Great Britain appears mired in a stagflationary environment. The new government has made a strong effort to cut the budget deficit causing protests in the streets. Economic growth is slow with inflation reaching for the 5% level sending the Bank of England into heated discussions over the possibility of raising interest rates.
As Europe faces a crisis of confidence capital is rushing into gold as a safe haven when one checks gold prices denominated in euros and pounds.
Investors need to ask themselves if the problems in Europe and Japan outweigh the problems in the US. With the problems overseas building it appears that the US dollar is going to be the safe haven for investors over the next few months. Investors looking for a way to hedge their portfolios over the summer timeframe by placing their money into the US Dollars have options outside of the plain old cash.
The Powershares DB US Dollar Index Bullish ETF (NYSE:UUP) seeks to replicate the performance of the US Dollar against the basket of currencies which make up the US Dollar Index. Investors cannot directly by the US Dollar Index directly and UUP seeks to replicate the performance of the index via the purchase of futures contracts.
More adventurous investors can go short the euro via the ProShares UltraShort Euro ETF (EUO) which seeks to replicate a negative 200% of the performance of the US dollar versus the euro via the use of derivatives.
The ProShares UltraShort Yen ETF (YCS) attempts to replicate twice the performance of the yen against the US dollar in a similar manner to the EUO.
EUO and YCS provide investors with a leveraged way to hedge their portfolios instead of holding money in cash while they wait for buying opportunities to arise.
Investors looking for a way to hedge their portfolios or trade off a depreciating euro, pound, or yen should take a look at the three ETFs mentioned above as they wait for buying opportunities to arise.
Disclosure: I am long UUP