ETFs to Watch as the Dollar Sinks

Among all the financial markets, perhaps the most unpredictable is the currency market. Even central banks, with their immeasurable firepower, can't reliably control what goes on when it comes to foreign exchange rates.

Case in point is the Bank of Japan and its relationship with the yen. Despite intervening in the currency market multiple times over the past couple of years, the central bank couldn’t stop the yen from sliding to multidecade lows. 

Then suddenly, when everyone least expected it, the yen reversed course in a violent move, appreciating over 10% versus the U.S. dollar in a matter of days earlier in August. 

The yen’s rebound and the dollar’s decline occurred suddenly. 

Indeed, strength in the U.S. dollar was taken for granted by most investors. Until recently, most were forecasting continued gains in the greenback due to the divergence in monetary policy between the U.S. Federal Reserve and other central banks.

Instead, this week the U.S. Dollar Index hit its lowest level since December.

Why The Dollar Is Falling

Which way the dollar ultimately goes is anyone's guess. But fundamentally, the factors that were keeping the currency supported are diminishing in strength, suggesting that perhaps the trend has shifted for the greenback. 

For one, the Fed has signaled that it is likely to cut rates at its next monetary policy meeting in September. A cooling of consumer price pressures and a softer labor market have caused the central bank to start worrying more about growth than inflation. 

If the Fed goes through with a cut, the direction of U.S. monetary policy will be more aligned with that of the rest of the world, while the gap between interest rates in the U.S. and elsewhere will narrow. All else equal, that’s dollar bearish.

ETF Impact

While it's too early to call an end to the dollar's run, if it happens, a trend-change in the dollar could have a significant effect on certain ETFs. Here are those that will be most affected:

Gold ETFs

The yellow metal often moves inversely to the dollar. Gold funds, such as the SPDR Gold Trust (GLD) and the iShares Gold Trust (IAU), could benefit.  

This week, gold topped $2,500 for the first time ever. Meanwhile, gold miner exchange-traded funds such as the VanEck Vectors Gold Miners ETF (GDX) have been stellar performers this year.

Currency ETFs

The most direct impact from currency moves will obviously be on currency-tracking ETFs. There are a handful of such ETFs with more than $100 million in assets.

The Invesco CurrencyShares Japanese Yen Trust (FXY) is the largest, followed by the Invesco DB US Dollar Index Bullish Fund (UUP), the WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU), the Invesco CurrencyShares Euro Trust (FXE) and the Invesco CurrencyShares Swiss Franc Trust (FXF). 

FXY has had a big bounce recently as the yen has appreciated, while UUP has slid due to the dollar’s weakness. 

Currency-Hedged ETFs

Currency hedged ETFs were in vogue over the past few years. These funds that hedge their international currency exposure performed well. As the dollar was climbing, ETFs, such as the WisdomTree Europe Hedged Equity Fund (HEDJ) and the WisdomTree Japan Hedged Equity Fund (DXJ), handily outperformed their plain-vanilla counterparts.

But now with the dollar falling, the situation has reversed, and the vanilla funds are outperforming thanks to their exposure to international currencies. If the greenback breaks down further, investors may gravitate toward vanilla international ETFs at the expense of currency-hedged ETFs.