The world’s reserve currency has been having a tough time as of late. The U.S. dollar touched a two-year low this week, ahead of the release of data that is expected to show the largest economic contraction in U.S. history.
Expectations are mounting that the dollar could fall further still, with some, like analysts at Goldman Sachs, going as far as calling this the end of the greenback’s reign as the globe’s preeminent reserve currency.
To be sure, analysts are often quick to call for profound market shifts, and those calls can be far off the mark. Still, this dollar decline is certainly worth acknowledging and keeping an eye on, as it has implications across asset classes and various ETFs.
This year’s dollar decline puts the U.S. Dollar Index at 93.35, the lowest level since May 2018. The index is down about 3.2% on a year-to-date basis, similar to the 2.9% decline for the Invesco DB U.S. Dollar Index Bullish Fund (UUP), the largest currency ETF on the market, with $354 million in assets.
While the long dollar fund has fallen, others that bet against the buck have rallied. The Invesco CurrencyShares Japanese Yen Trust (FXY) has gained 3.2%; the Invesco CurrencyShares Euro Trust (FXE) is up 4.5%; and the Invesco CurrencyShares Swiss Franc Trust (FXF) returned 5.4% since the start of the year.
If the greenback keeps slipping, these are the ETFs that stand to directly benefit—though, it’s not yet clear whether the dollar will drop precipitously from here. A look at the U.S. Dollar Index reveals that the currency is still very much in the range it’s been in since 2015, largely between 93 and 100. There was even a brief foray below that range in early 2018, when the index slipped to 88.60, before recovering those losses in subsequent months.
A five-year range is no easy thing to break.
US Dollar Index (2015-2020)
Dollar bears argue that current circumstances are much different than they were between 2015 and 2019, when the Federal Reserve was steadily hiking rates, widening the gap between U.S. yields and yields in other developed countries.
Higher rates in the U.S. compared to elsewhere worked in the dollar’s favor back then, but that support is no longer there.
Today the Federal Reserve’s benchmark is pegged near zero, and the Fed suggests it will stay there for at least a few more years—if not longer. On top of that, the federal government is spending trillions of dollars to support the economy, much of it financed by the central bank.
Some worry that all of this spending and liquidity will find its way into the economy, leading to rapid inflation and a reduction in the dollar’s purchasing power. There were similar theories in the aftermath of the 2008 financial crisis, though the stimulus measures of that period never ignited inflation.
The difference is, the accommodation in 2020 is orders of magnitude larger than it was during the last recession, and Fed officials have made it clear they may let inflation pressures build up more than they normally would before raising rates.
Between 2008 and 2014—the period when the federal funds rate held near zero—the U.S. Dollar Index averaged 80, notably lower than current levels. It only took off in 2015, when the Fed began hiking rates.
If monetary stimulus today is looser than it was 10 years ago, shouldn’t the dollar at least be as low as it was back then?
US Dollar Index (2005-2020)
There is obviously a case to be made that it should be, but currency markets are notoriously difficult to predict. All sorts of things could keep a bid under the greenback, keeping it from falling further—safe haven demand, an acceleration in the U.S. economy in the months to come, or troubles overseas, to name a few.
Gold & Commodities Gain
Regardless of where the dollar heads from here, it’s going to have an impact on other assets, especially if the trend shifts to a downward path.
Gold, and to a lesser extent, other commodities, usually benefit from a weaker greenback. They’re all denominated in dollars, making them cheaper for overseas buyers when the buck drops. Gold is usually one of the biggest winners in a falling dollar environment thanks to its status as an alternative store of value among many investors.
The yellow metal hit a record high of $1,981/oz earlier this week, while silver hit a seven-year high above $26. The SPDR Gold Trust (GLD) is up 28.6% year to date, while the iShares Silver Trust (SLV) is up 34.7%.
Another 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).
But they may not want to. Currency-hedged products tend to underperform their vanilla counterparts when the dollar is falling (and vice versa).
Also, 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 invested in international stocks or commodities, the dollar’s movements still have an impact. For instance, a weaker dollar makes U.S. exporters more competitive and increases the profits of multinational companies that conduct much business overseas.
That doesn’t necessarily mean investors have to make dramatic shifts to their portfolios in response to fluctuations in the buck, but they should understand how such movements may affect their returns.
Should the dollar weaken further, it’s potentially another supportive factor for large cap ETFs compared to funds with smaller cap tilts. The SPDR S&P 500 ETF Trust (SPY) is up 1.5% year to date, compared to an 9.8% loss for the iShares Russell 2000 ETF (IWM). Though most of that difference can be attributed to SPY’s overweight exposure to mega cap tech, the dollar may play more of a factor in relative returns going forward.