Since peaking at a 20-year high at the end of September, the U.S. Dollar Index dropped nearly 8%, as a result of cooling inflation and the Fed eyeing slower rate hikes, exerting downward pressure.
This could merely be a bump in the road for the greenback, or it could be the start of a more protracted downtrend.
While currency markets are notoriously fickle, the buck historically takes its cues from the trajectory of U.S. interest rates versus rates in other parts of the world. These interest rate differentials play a big role in driving currency fluctuations in the short term.
If the dollar has peaked because the Fed is close to ending its rate hiking campaign, while central banks elsewhere continue to hike their benchmark rates, what would that mean for exchange-traded funds?
While the dollar’s effect on ETFs is usually nuanced, one area where the impact is most clear is currency ETFs.
If the greenback retreats, ETFs that track the currency—like the $2 billion Invesco DB U.S. Dollar Index Bullish Fund (UUP) and the $379 million WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU)—will also fall.
On the flip side, a decline in the dollar will benefit ETFs that bet against the buck—like the Invesco DB U.S. Dollar Index Bearish Fund (UDN), the Invesco CurrencyShares Euro Trust (FXE), the Invesco CurrencyShares Swiss Franc Trust (FXF) and the Invesco CurrencyShares Japanese Yen Trust (FXY).
Outside of currency ETFs, a declining dollar has a more ambiguous impact.
On the one hand, a cheaper dollar adds to the returns for ETFs that hold foreign-currency-denominated assets. When an investor holds these funds, they are simultaneously long the underlying assets and the currency that those assets are denominated in.
If the foreign currency rallies against the dollar, it amplifies the funds’ returns and vice versa.
For example, since the end of September, the iShares MSCI United Kingdom ETF (EWU) is up 20%, nearly a double gain for the underlying MSCI United Kingdom Index—the difference attributed to the 9% rally in the British pound versus the U.S. dollar in the same period.
At least in one respect the sinking dollar is bullish for international ETF, but there’s another side to consider as well: A stronger currency makes exporters less competitive.
For ETFs that provide exposure to export-dependent countries—like Japan and Germany—the negative impact of reduced exporter competitiveness might offset the positive impact of the currency conversion boost to returns.
Ultimately, investors need to determine how currency fluctuations impact their returns as well as what time frame they're considering.
It could be at the stock level, where the underlying holdings of an ETF are denominated in a particular currency. Or it could be at the company level, as in the example of exporters discussed above.
In addition to impacting exports, currency movements can impact imports. Many countries today would benefit from an appreciating currency, as it makes imports of key commodities like oil and food cheaper, helping to bring down inflation. But at other times, when inflation is less of a concern, they may prefer a weaker currency.
Currently a falling dollar would also help U.S. multinationals by both increasing their export competitiveness and increasing the value of the profits they generate overseas (when translated into U.S. dollars).
There are a lot of factors to consider, making it difficult to say whether an increase or decrease in the dollar is bullish or bearish.
But at least this year, when the dollar’s ascent to 20-year highs has been driven by strains in financial markets and economies, we can say that a U.S. dollar pullback is generally a positive for both U.S. and international stock ETFs.