Considering a Dollar Decline

Includes: UDN, UUP
by: Don Dion

As the U.S. financial crisis rippled outward to the larger global economy, and as the plight of other nations dwarfed that of our own, an increasing number of Americans and foreign investors have poured resources into the U.S. dollar. The resulting bounce has helped our native currency recoup more than two years’ worth of losses, according to the Wall Street Journal, while the dollar has strengthened 23% against the euro and 34% against the British pound since early August. Such a rally inevitably begs the question of its sustainability, and as analysts cast doubt on the future of the dollar gain, ETF investors have shifted interest from PowerShares DB U.S. Dollar Index Bullish (NYSEARCA:UUP) to PowerShares DB U.S. Dollar Index Bearish (NYSEARCA:UDN). While the U.S. experiences a relative calm in its equity markets, or basks in the eye of the hurricane, a new—more bearish—dollar view may be in order for investors.

UUP and UDN both sit atop the Sector Momentum Tracker International Momentum Table, holding the third and fourth positions, respectively, as of December 15. The increase in momentum has been a result of rapidly changing conditions for the U.S. dollar in 2008. With the dollar dropping 7% since Thanksgiving, many formerly bullish dollar investors are beginning to hedge their bets for the new year with rising UDN.

While one might hedge the dollar’s decline by directly buying the currencies of other nations, UDN offers the flexibility of getting a diversified short dollar bet in one place—with the availability of intraday trading on home turf. UUP and UDN allow investors to make long and short bets, respectively, on the direction of the dollar. Both the long bet, UUP, and the short bet, UDN, utilize futures contracts tied to the U.S. Dollar Index. This index measures the dollar against a basket of six other currencies: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. Relative strength in the dollar boosts UUP, while weakness strengthens UDN.

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Some analysts have argued that the fall of the dollar, and the subsequent rise of UDN, is imminent; others believe that the dollar rally may still have legs into early 2009. “We are roughly halfway through the rally in the dollar,” said Stephen Jen, global head of currency research at Morgan Stanley, in early December. Jen also predicted a dollar decline in the second half of 2009 as the full ramifications of recent bailout programs become evident.

The decline of the dollar would have both positive and negative effects on individual investors and the economy. The recent boost in relative valuations has allowed many Americans to travel abroad at a more reasonable expense—a trend that would ultimately reverse if the dollar were to weaken. At the same time, a weaker dollar would be a boon for U.S. exports, making them more competitive with similar products manufactured abroad.

The task for investors and analysts alike will be to determine the effect that the expanded Federal Reserve balance sheet will have on the dollar as the market improves. The Fed in recent months has faced the task of walking an increasingly thin line between the threat of deflation and that of inflation. Many believe that the massive cash injections into the economy will prove inflationary, eroding the value of the dollar and boosting the value of short bets like UDN in 2009. Others contend that the Fed will be as aggressive in raising rates as it was in cutting them in order to stem inflation—a daunting task, at best, in bleak economic conditions.

If the dollar continues to slide, investment opportunities like UDN will help put investors on the right side of the curve. A decline in the dollar could also spur Amer- icans to purchase foreign stocks once again, a trend that has decreased dramati- cally as market conditions at home and abroad deteriorated and as returns were diminished by conversion rates. A drop in dollar value would also benefit compa- nies doing business both in the U.S. and abroad. These companies have seen a decline in profits as they convert other currencies into a stronger dollar—a trend that would reverse if the dollar weakens.

Those who continue to back the dollar argue that the U.S. situation will continue to look rosier than problems abroad. If the current financial crisis continues to erode economies abroad at a faster rate than it does the market at home, many argue that the dollar will continue to show strength against currencies such as the yen. Other investors in products like UDN, however, are willing to bet that some of the aggressive measures taken by the U.S. government will produce some sort of slow rally and a fall in the dollar. Both theories hinge on predictions concerning the duration of the economic crisis and our current position in it—an issue that both UUP and UDN fund holders will have to contend with in upcoming months.