Foreign Currencies: Opportunity for Gains Amidst General Decline

The month of February ended with a thud - the fourth consecutive monthly decline for equity indices. Uncertainties in the market abound and volatility levels are high. Amid these conditions, investors have found shelter in areas few and far between. With the United States entrenched in a rate cutting cycle, even money market funds are becoming a less attractive option. Where should investors look for an alternative with upside potential? Foreign currencies are an asset class on the rise in US Dollar terms over the last seven plus years, and they have made measurable moves to the upside since the first of this year.

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Source: Cashing in on Currency: An Asset Class to Help Diversify Your Portfolio. Rydex Investments.

Since peaking in 2001, the U.S. dollar has been in steady decline versus a range of foreign currencies. This past week, the Euro hit an all-time high versus the US Dollar at 1.52. The story is similar across many foreign currencies including the Australian Dollar, which hit a 24-year high versus the US Dollar last Thursday. The Swiss Franc is at record highs versus the US Dollar and the Japanese Yen is at a 3 ½ year high. Some market prognosticators have called for a dollar bottom on the horizon, but the driving force behind the decline should continue for some time.

With the Federal Reserve concentrating on mitigating problems in the credit arena, monetary policy in the US will continue to tighten. Fed Chairman Bernanke hinted in his testimony before Congress last week at the need for additional rate cuts at the March 18 FOMC meeting. Fed funds futures now price in a 50 basis point rate cut with odds rising for a 75 basis point cut. This stance on monetary policy differs greatly with other central banks around the world. The Reserve Bank of Australia on Tuesday raised their key interest rate by 25 basis points to 7.25 percent. The European Central Bank has not yet hinted of an impending easing cycle. With banks outside of the US continuing to focus on inflation, the dollar will continue to weaken. This combined with declining US money market rates makes cash investments in US Dollars even less attractive.

While the average individual investor has most likely benefited from foreign currency appreciation indirectly through investments in international equity and fixed income, several vehicles are now available for investors to directly invest in foreign currency. CurrencyShares, an ETF provider, has a family of funds linked directly to currencies including the Euro (FXE), the Australian Dollar (FXA), the Japanese Yen (FXY), the Swiss Franc (FXF), the British Pound Sterling (FXB), the Swedish Krona (FXS), and the Mexican Peso (FXM). The ETFs are direct plays on individual currencies so investors must make a decision on which currency / currencies provide the best prospects.

For investors looking to gain more tactical exposure to currencies, PowerShares offers the DB G10 Currency Future Harvest Fund (DBV). This fund is comprised of long futures contracts on three G10 currencies exhibiting the highest interest rates, short futures contracts on three G10 currencies exhibiting the lowest interest rates, and US 3-month Treasury Bill futures contracts. The performance of the funds underlying index have been impressive, outperforming the S&P on a one year and three year basis. The index returned nearly 10 percent over the last one year, 10 percent annualized over the last three years, and 11.50 percent annualized over the last five years.

Two currencies we currently favor are the Euro (FXE) and the Australian Dollar (FXA). The Euro is currently yielding 3.74 percent and has appreciated in price 4 percent since the first of the year. The Australian dollar has a current yield of 6.35 percent and has appreciated over 6 percent since the first of the year. Both of these currencies present an excellent case for investment.

Foreign currencies present an attractive opportunity for investors in these times of uncertainty in the stock market. With virtually no correlation to the S&P 500, an allocation to foreign currencies should help lower risk in an investment portfolio and present an opportunity for gains in an otherwise declining period for equities.

Disclosure: Kenjol clients and/or employees currently maintain long positions in FXE, FXA and DBV.

Comments

[sbenard]

I agree on FXE and FXA, but DBV has plummeted recently. There are now some new currency ETNs by Elements that have some tax and other advantages over these older ones that appear to provide higher returns. These new ones have only been available for a few days. (No, I don't own them or work for Elements; I just want people to know all their options.)

[dlevy]

I do agree with sbenard that DBV has been struggling as of late. DBV is not working because the fund is short currencies in a period when almost all currencies are appreciating versus the US Dollar, including the Yen which continues to hit multi-year highs. That said, the back-tested data provided by PowerShares is compelling over a longer time frame.