Whither the Dollar? Currency Trends and ETFs

For most investors who keep tabs on market trends, it’s no secret that the U. S. dollar has had a tumultuous year. On July 15, for instance, the venerable greenback sank to an all-time low against the euro, the currency of the 15-nation Eurozone. On that day, you would have received a little less than two-thirds of a euro in exchange for your dollar. That was a far cry from October 2000, when the dollar fetched a record €1.20. Over the summer, the dollar experienced similar slumps against other widely traded major currencies, including the British pound.

More recently, however, the dollar has experienced a dramatic reversal of fortune, as the economies of Europe and Asia weather the same economic storm that first hit the U.S. last year. Is the dollar just bouncing off its summertime lows, or is this rebound the beginning of a new upward trend?

The global currency markets can be difficult for investors more familiar with the principles of stock and bond investing to navigate. Depending on what you were holding in your portfolio—and when you made your trades—this year’s drop in the dollar may have triggered sudden unforeseen losses or created an unexpected windfall. In our global marketplace for goods and services, movements in the currency markets can affect even the most conservative investments.

Because currency markets were largely off-limits to individual investors until just a few years ago, most of us aren’t familiar with the mechanics of these seemingly opaque and complex markets. What makes a currency strong or weak? Is a strong dollar “good” or “bad” for investors? Which sectors thrive in a rising dollar environment? A falling one?

There aren’t many simple answers for investors hoping to profit from movement in the currency markets , but there are some basic economic effects of a weak dollar that nearly everyone agrees on. When the dollar loses value against foreign currencies—the most widely used benchmarks are the euro, the Japanese yen and the British pound—U.S. goods become more competitive in the global marketplace. At the same time, commodities—at least those denominated in dollars—tend to rise in price.

Why? It’s a simple matter of the exchange rate. In July 2008, a European customer of a U. S. machine tool manufacturer, for instance, could get nearly twice as much value for his euro as he could in October 2000—two lathes, drill presses or grinders for the price of one. The same products made by a European manufacturer would be twice as expensive for an American customer.

That basic principle also applies to commodities. Energy analysts frequently point to the currency markets as playing a role in the record run-up in oil futures earlier this year. Those contracts are priced in dollars, so when the dollar loses ground in the currency markets, it takes more dollars to buy the same amount of oil.

So how does all this help investors? A simple way to take advantage of a weak dollar—and the competitiveness of U.S. goods abroad—is to invest in sectors that export heavily. Industrials, aerospace and defense, and information technology are commonly thought of as sectors that thrive in a weak-dollar environment. U.S. companies that operate in these areas derive much of their income from abroad; a favorable rate of exchange provides an added boost to profits when domestic growth is strong and can help offset losses in the U.S. during a downturn.

While this “export” thesis is appealing in theory, it hasn’t delivered the dramatic results in recent months one might have hoped, particularly given the record-setting lows we saw in the dollar this summer. As of early September, PowerShares Aerospace and Defense (PPA) was about 7 percent off its year-to-date low, but investors are understandably tentative about this sector (whose fortunes depend as much on which way the political winds are blowing as on the strength of overseas markets) ahead of the presidential election. The iShares Dow Jones U. S. Industrial Index Fund (IYJ), with top holdings that include General Electric (GE), United Technologies (UTX) and 3M (MMM), is also currently off its midsummer low, but it’s still about 16 percent below its October 2007 high water mark.

Should investors flock to foreign currency ETFs to hedge movements in the dollar? With caution. Rydex and PowerShares have opened up this market to investors, with innovative products that allow investors to incorporate direct currency exposure into their portfolios. Most long-term investors, however, should use these funds sparingly. Using a Rydex CurrencyShares fund that holds the currency of a stable and strong economy, such as the Swedish Krona Trust (FXS), to replace part of a cash position is one good way for a long-term buy-and-hold investor to take advantage of these innovative products.

As always, investors have one eye on the recent past and one eye on the future. The dollar has been gaining ground in recent weeks, but will it keep going? While several factors affect the movement of the dollar, the most important of these is probably the interest rate the Federal Reserve sets in its Federal Open Market Committee meetings every six weeks. As a general rule, higher interest rates support a strong dollar, while lower interest rates contribute to a weak dollar. The Fed began cutting rates aggressively in the second half of 2007 but has been on hold more recently. If the economy stabilizes and employment picks up in the next several quarters, look for the Fed to begin raising the key federal funds rate from its current level of 2. 0 percent—and for the dollar to continue gaining strength.

Comments

[hedgeman:]

Is the dollar just bouncing off its summertime lows, or is this rebound the beginning of a new upward trend?

USD is in correction mode (DX 81.xx target). Still surprisingly fast advance, no corrections, official names can be "felt" in the market action. Don't let behind the doors deals between US and Asia (China) fool you into thinking USD is now fundamentally bid. It is still fundamentally weak however since the latest carnage USD shorts will be more carefull and the rate of descent will be slower. Our target remains DX 65.xx zone, however it is hard to estimate the interval (well it is always hard, harder this time since govie USD bulls do not follow the same investing rules as other players) Best guess at moment 2q 2009....
We still remain JPY bulls (ag. EUR and USD).

Disclosure: short EURJPY and USDJPY

2008 Sep 12 11:14 AM

[dlaw:]

The dollar is experiencing the anti-bubble in the euro - and indeed in oil and the basket of world currencies.

It will rest here and then rise very quickly. A week or so from now should be a good time to go short again.

I've said it before and I'll say it again: $1.30 is a mortal lock.

Disclosure: I have no financial positions in anything.

2008 Sep 12 06:23 PM

[dlaw:]

that's "EUR/USD" $1.30 is a mortal lock

2008 Sep 12 06:23 PM

[CaptBob:]

"As always, investors have one eye on the recent past and one eye on the future."---above

Between future and past my eyes are doing temporary duty on todays grocery bag.
They say I have to save my dollars at 11% interest for them to buy the same loaf of bread next year.

Is this math simple for you or do you believe the Govt's #'s at 4%??
If so, good luck to you and go back to the complicated mumbo-jumbo that leaves you thinking .5 basis points is too much to even consider.

I took out a dollar--all it would morph into was an airplane--that seems like a lot till you find out many times you have to throw it for 1 frequent flyer mile!!, Same with a $20,--strange??

2008 Sep 13 10:28 AM

[Danny/The D...:]

I simplify currency risk by investing in Vanguard Energy fund, which is comprised of approximately 50% US domiciled corporations and 50% foreign. The US based corporations are mostly multinationals that derive much of their revenues from operations in foreign countries.

Having invested since 1963 in international and global securities, I have observed the unpredictable and mysterious gyrations of the USD and precious metals. I'm content to "keep it simple stupid" (KISS) by investing indirectly in hard assets: oil, natural gas, coal, uranium for nuclear power, etc. and to employ patience to realize my gains.

Patience is as important as timing.

2008 Sep 13 01:11 PM

[NOWHEREMAN:]

The difference between patience and timing is the entry point itself, if the entry point is low enough one can afford to have patience. Timing allows one to have that patience without undue stress.

I started investing in the CanRoys when oil was at $25, I watch the gyrations without stress. And don't care if oil drops to $80 or less, I can afford to have patience. However, those who entered oil at its peak this year, or bought solar/coal shares at those peak levels are being reamed and now are roaming through the various articles trying to justify their investments by extolling their virtues.

The best will remain the best but are not immune to corrections. Whether real or not, perceptions are fundamental to both Bear and Bull markets. The current perception is that of a BEAR market in commodities. A Sky is Falling Scenario has been applied tp Global Growth. Oil/Solar/Coal stocks are all energy plays and all are suffering. Pure plays in Wind are few and far in between. They can buck the trend because those wishing to invest in them have very limited choices, especially in the US on any major exchange.

So I would postulate that timing is more important than patience. Unless you are getting paid an extraordinary dividend while you wait.

Just MHO.

2008 Sep 14 01:48 AM

[dlaw:]

Danny, there's also this thing called "ringing the register".

You're not looking to put crude oil in your pocket, but cash.

Oil is crashing. Get out.

2008 Sep 14 03:57 AM

[elwind45:]

What about intervention? At some level one of two things will happen. The US will lower rates to save exports and/or bank balance sheets or world central banks will sale dollars back to treasury. Has any one noticed KOREA? The U.S. economy is pretty much banking on continued strong exports. With a double negative of slowing world growth and or export growth the strong dollar is history. What are odds of ECB lowing rates to combat falling EURO. Europe has raised interest rates during weak economic periods in past, to combat import price inflation. I would bet on intervention coordinated (the US government is the idiot in this equation! happy trading ( STRONG DOLLAR= TOO MUCH TUBE)

2008 Sep 14 06:00 AM