The trillions of dollars of monetary and fiscal stimulus unleashed by the U.S. government has been a boon for most assets. Stocks, commodities and cryptocurrencies have moved in a straight line upward since last March as a deluge of liquidity has buoyed asset prices across the board.
But one important asset has moved in the complete opposite direction—the U.S. dollar.
Since reaching a three-year high on March 20, 2020, the greenback has steadily declined. The U.S. Dollar Index, which measures the buck against a basket of foreign currencies, reached a low of 89.2 last week, its cheapest level in three years. The index closed Wednesday at 90.35.
US Dollar Index
It’s obvious why the dollar has depreciated over the past 10 months. All else equal, more dollars in circulation results in a reduction in the purchasing power of the greenback. This manifests itself in the form of inflation, and indeed, market expectations for inflation are at the highest levels since 2018.
At the same time, interest-rate differentials—which often drive currency movements in the short term—have moved sharply against the buck. Whereas U.S. interest rates were significantly higher than those in other developed countries before the pandemic, the gap is almost nil today. That reduces the appeal of U.S. cash and fixed income assets vis-a-vis their international counterparts.
Dollar ETF Sags
With the greenback in retreat, ETFs that track the currency have fallen. The $359 million Invesco DB U.S. Dollar Index Bullish Fund (UUP) is down 7.4% over the past year.
On the other hand, ETFs that bet against the buck—like the Invesco CurrencyShares Euro Trust (FXE), the Invesco CurrencyShares Swiss Franc Trust (FXF) and the Invesco CurrencyShares Japanese Yen Trust (FXY)—have rallied by 8.6%, 8.3% and 5.3%, respectively, over the past year.
1-Year Returns For UUP, FXE, FXF, FXY
While currency ETFs are those most directly affected by the dollar’s movements, other funds are impacted indirectly. Commodities, for example, are denominated in dollars, and sometimes see a boost in demand on the margin as the dollar declines (and vice versa).
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 those not 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 of their 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.
Indeed, predicting where the dollar goes from here is nearly impossible, as currency markets are notoriously difficult to predict. When Democrats officially won the two Georgia Senate runoff races on Jan. 6, many had expected a steep sell-off in the dollar in anticipation of a big jump in stimulus spending.
Instead, the date marked a low for the dollar, which has climbed modestly since. Perhaps it’s too early to write the obituary for the dollar. After all, the last time the buck fell to these levels, during the spring of 2018, it proceeded to bottom out and then steadily rise over the next two years.
Bull Vs. Bear
The bullish case for the greenback is that inflation picks up, pushing the Fed to hike rates sooner than expected. The 10-year Treasury bond yield, which is set by the market (and strongly influenced by the Fed’s bond purchases), hit a 10-month high near 1.2% this week on expectations of more bond supply and building inflation pressures.
On the other hand, perhaps this week’s little bump in the dollar is just a temporary countertrend rally, and the buck will head back down as government spending picks up and rates stay low. If that’s the case, keep an eye on the 88 level in the U.S. Dollar Index. That’s the trough from 2018, below which the dollar hasn’t traded since 2014.
US Dollar Index