Inflation concerns are causing interest rates to spike, lifting the U.S dollar in the process. The greenback is still one of the strongest currencies around, and has been trading at close to the highest levels in 1 1/2 years.
The $717 million Invesco DB U.S. Dollar Index Bullish Fund (UUP), which tracks U.S. Dollar Index futures, is up 6.4% over the past year.
US Dollar Index
The U.S. dollar has been rising in large part due to the expectations that the Federal Reserve will begin hiking interest rates in the coming months. Treasury yields across the yield curve leapt to multimonth highs this week as it became increasingly clear the latest variant of COVID-19 was less deadly than previous variants.
That makes it likely that the U.S. central bank will tighten monetary policy fairly aggressively this year, first by tapering its bond purchases, then by raising its benchmark federal funds rate.
As the Fed is acting more aggressively than most of its central bank peers around the world, the dollar benefits. Higher rates attract capital into dollar-denominated assets relative to assets denominated in other currencies.
For ETF investors, the dollar’s strength has repercussions, both direct and indirect. The most straightforward impact is on currency ETFs like the aforementioned UUP, or the Invesco CurrencyShares Euro Trust (FXE) or the Invesco CurrencyShares Japanese Yen Trust (FXY) or the WisdomTree Chinese Yuan Strategy Fund (CYB).
ETFs with long exposure to the dollar have been doing well, while ETFs with long exposure to rival currencies have been performing poorly. Currency ETFs are good tools for investors to use to bet on that trend either continuing or reversing.
Even for investors uninterested 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 much 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 over the past year—it’s underperformed SPY—but it could if the dollar becomes a bigger factor.
Another area in which currencies play a big part is 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 climbing (and vice versa).
However, 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).
Follow Sumit Roy on Twitter @sumitroy2