Surging interest rates have been a drag on most ETFs this year. You can draw a direct link between the rise in rates and the weakness seen in popular ETF categories, like bond ETFs and high-growth stock ETFs.
But not every ETF is suffering from higher interest rates. Funds tied to the U.S. dollar have actually benefited from the increase in rates. The $1 billion Invesco DB U.S. Dollar Index Bullish Fund (UUP) is up 5% this year, while the $440 million WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU) is up 3.5%.
Higher rates make the U.S. dollar relatively more attractive compared to foreign currencies. That pushes capital into dollar assets, lifting the greenback’s exchange rate versus its peers. The positive correlation between rates and the dollar doesn’t always hold—especially over long periods of time, when purchasing power and inflation are bigger factors—but it can be a dominant driver over shorter time periods.
The U.S. Dollar Index, one of the most widely followed gauges of the dollar’s value and the index underlying UUP, recently topped 100 for the first time in two years. The index—which measures the value of the dollar against the euro, yen, pound, Canadian dollar, krona and franc—has been hovering in range between 88 and 103 since 2015:
The Bloomberg Dollar Index, which underlies USDU, tracks a broader basket of10n currencies—including the Chinese renminbi and the Indian rupee—shows a similar pattern, though it’s not quite back to its highs from 2020:
UUP’s greater exposure to the USD/EUR exchange rate has served it well this year as the euro has fallen sharply against the buck. The ETF’s lack of exposure to certain emerging market currencies, like the renminbi and rupee—which have held up pretty well against the greenback recently—has also helped it outperform.
Keep An Eye On The Range
Investors will be closely watching to see whether the dollar holds within its seven-year range or if it has enough juice to break out to new heights.
The most plausible bull case for the greenback rests on inflation staying elevated, pushing the Fed to respond by hiking rates much more aggressively than expected. Any black swan events that spur a flight to safety should also benefit the buck.
On the other hand, if inflation cools off quickly and the Fed doesn’t have to hike rates as high as the market expects, that could stop the dollar rally in its tracks.
The aforementioned currency ETFs are those most directly affected by the dollar’s movements, but other funds are impacted as well—just in a more indirect way. One area where movements in the dollar play a big part is with international equities. Anyone invested in foreign stocks is making at least a tacit bet on currency movements.
For example, the returns for a vanilla, unhedged position in German stocks in a U.S. investor’s portfolio will be influenced both by the performance of the underlying equities and the performance of the euro against the U.S. dollar.
Investors can hedge that risk with a plethora of currency-hedged ETFs available on the market, including the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF), the WisdomTree Japan Hedged Equity Fund (DXJ), the WisdomTree Europe Hedged Equity Fund (HEDJ) and the iShares Currency Hedged MSCI EAFE ETF (HEFA).
Currency-hedged products tend to outperform their vanilla counterparts when the dollar is rising (and vice versa).
Keep in mind that it doesn’t always make sense to hedge currency risk, even when you have a strong view on a particular currency. In some cases, the cost to hedge is prohibitively expensive, such as when hedging currencies with high interest rates (e.g., emerging market currencies).
Even for investors who aren’t interested in speculating directly on foreign exchange rates, currencies still have an impact. That doesn’t necessarily mean investors have to make dramatic moves to their portfolios in response to fluctuations in currencies, but they should understand how such movements may affect their returns.
For instance, a stronger dollar makes U.S. exporters less competitive and reduces the profits of multinational companies that conduct a lot of their business overseas.
Similarly, small cap stocks, such as those held in the iShares Russell 2000 ETF (IWM), tend to have less overseas exposure than the large cap stocks held in the SPDR S&P 500 ETF Trust (SPY). That hasn’t really helped IWM this year—it’s underperforming SPY—but it could if the dollar becomes a bigger factor.
Follow Sumit Roy on Twitter @sumitroy2