What Is The Outlook For UDN Amid The Upcoming Fed Meeting?

About: Invesco DB US Dollar Index Bearish ETF (UDN)
by: Sankalp Soni

The UDN ETF is down by about 9.34% from its 52-week high.

The general weakening in economic data encourages a dovish shift by the Fed.

The market could potentially be anticipating a too dovish Fed, which could hurt UDN performance if Powell does not deliver.

The Invesco DB US Dollar Bearish (UDN) ETF, which inversely tracks the US Dollar against six predominant global currencies, is down by about 9.34% from its 52-week high in February 2018, and is currently trading at around $21. While the hawkish Fed for most of this year had strengthened the USD, the recent shift towards dovishness could help reverse plunge in the UDN ETF. This article assesses recent developments to determine how the Fed could communicate with markets on Dec. 19, and examines how the UDN ETF will move accordingly.

Source: Yahoo Finance

Prospectus Review:

The objective of the UDN ETF is to inversely track the Deutsche Bank Short US Dollar Index Futures Index. It aims to short the Dollar Index using futures contracts against six major currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. The annual net expense ratio of the ETF is 0.76%, which is actually above the 0.71% average expense ratio of other ETFs that offer bearish exposure to the USD. However, the ETF offers more diversification in comparison to its peers.

The fund seeks to track the index by establishing short positions in DX Contracts. DX Contracts are linked to the six underlying currencies, or the index currencies, of the U.S. Dollar index (USDX®), or the USDX®. The index currencies are Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. The annual net expense ratio of the ETF is 0.76%.

Source: Invesco

Risk Note from UDN prospectus:

Because the value of the USDX could, in theory, rise infinitely, a short position in DX Contracts exposes the Fund to theoretically unlimited liability. The Fund’s losses could result in the total loss of your investment.

The distinctive reason I have chosen this particular ETF to short the USD is because the fund's strategy incorporates shorting the USD against various different currencies of developed countries, mitigating the risk of solely being exposed to just one currency to short the Dollar against, thereby offering more diversification. For instance, if it the ETF were to only short the USD against the Japanese Yen, then this would undermine investors' ability to short the USD in anticipation of a dovish Fed if the Bank of Japan was also increasingly dovish. Hence the fact that the fund's holdings are more diversified makes it a more appealing investment vehicle.

Inflation data does not support hawkishness

On Dec. 12, Consumer Price Index (NYSEARCA:CPI) data for November was released for November, which matched expectations as year-over-year (yoy) came in at 2.2%. The chart below shows how CPI has been on a declining trend since the middle of this year, which should inhibit the Fed from being overly hawkish.

Source: Wall Street Journal

Furthermore, ‘Personal Consumption Expenditure (PCE)’ is perceived as Fed’s preferred inflation measure. The core PCE for October came in at 1.8%. While the measure had hit the 2% target in March this year, it has since dropped, which is further likely to discourage the Fed from hiking rates aggressively going into next year. This is likely to weaken the US Dollar, and help drive the UDN ETF higher.

Mixed jobs data

Job Openings and Labour Turnover Survey (JOLTS) data on Monday revealed that 7.079 million jobs were created in October, beating the estimate of 7 million.

It is worth noting that this number is well above the number of people unemployed at the moment, which is at 5.975 million. This could indicate tightening labor market conditions, and support wage inflation. This could pose a risk to the bearish USD trade, as it could undermine the level of Fed’s dovishness in next week’s meeting. Given that the market is currently expecting a very dovish Powell on Dec. 19, less than expected dovish attitude could support the USD from falling lower, which would consequently disappoint UDN investors.

Nevertheless, last week’s big employment report November indeed indicated a weak jobs number for November, and the fact that wage growth came in at 3.1%, missing the consensus of 3.2%. Hence, the market is still right to expect a more dovish Fed next week. Although I would note that investors stay prepared for a potentially mixed statement from Powell, whereby he may not be as dovish as the market is pricing in, which could possibly undermine the performance of the UDN ETF.

Bottom Line

Markets are highly anticipating the Fed to turn more dovish on Dec. 19, which would help support the UDN ETF higher. However, I would recommend investors stay cautious in the event that Powell fails to deliver on the level of dovishness expected from him next week, which could potentially pose a risk to the outlook of the UDN ETF.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.