How Falling Dollar Impacts ETF Investors

Out of 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. With all the quantitative easing and negative rates that the BoJ threw at the market, everyone believed the Japanese currency could only head lower. Instead, it fooled everyone and went the other way.

On Monday, the yen traded at its strongest level against the U.S. dollar in 1 1/2 years.

Dollar-Yen Exchange Rate (USD/JPY)

This year, the dollar has been weakening against the yen.

Meanwhile, the U.S. dollar was expected to be a one-way trade for the foreseeable future. Up until recently, most analysts 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, the U.S. Dollar Index this week briefly hit its lowest level in more than a year.

U.S. Dollar Index

The U.S. Dollar Index is testing the lower end of its one-year trading range.

As can be seen from the chart above, the U.S. Dollar Index is revisiting the bottom of a trading range that's been in place for nearly a year. A break below these levels would be interpreted as bearish by technical analysts, and may open the door to even lower values for the buck.

Why The Dollar Is Falling

Which way the dollar ultimately goes is anyone's guess. But fundamentally, the factors that drove the currency to lofty heights in 2014 and 2015 seem to be diminishing in strength, suggesting that perhaps the greenback's best days are behind it.

For one, the Fed has significantly toned down its language with regard to rate hikes. In light of surprisingly tepid economic data―first-quarter U.S. GDP grew only 0.5% annualized, the slowest pace in two years―the central bank has kept interest rates steady this year after hiking them for the first time in nearly a decade in December.

Taking heed of the data, traders in the Fed funds futures market have little conviction there will be even one rate hike later this year.

Without rate hikes, U.S. central bank policy is much closer to that of the rest of the world. That's dollar bearish.

At the same time, the rebound in commodities and an improvement in sentiment regarding emerging markets have propelled those countries' currencies higher against the dollar as well. Back in March, emerging market currencies had their best month in 18 years.

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 will have a significant effect on certain ETFs. Here are those that will be most impacted:

Gold ETFs

The yellow metal often moves inversely to the dollar. All year long, investors have been plowing money into gold funds such as the SPDR Gold Trust (GLD | A-100) and the iShares Gold Trust (IAU | B-100) in anticipation of further depreciation in the U.S. currency and volatility in financial markets.

This week, gold topped $1,300 for the first time since January 2015. Meanwhile, gold miner exchange-traded funds such as the VanEck Vectors Gold Miners ETF (GDX | B-57) are among the best-performing of all ETFs this year.

Currency ETFs

The most direct impact from currency moves will obviously be on currency-tracking ETFs. These funds aren't that popular with investors, but there are three such ETFs with more than $100 million in assets.

The PowerShares DB US Dollar Index Bullish Fund (UUP | B-73) is the largest, followed by the UltraShort Euro ETF (EUO). Both these ETFs have been sliding recently as the dollar pulled back.

On the other hand, the Guggenheim CurrencyShares Euro Trust ETF (FXE | B-98), the Guggenheim CurrencyShares Japanese Yen Trust ETF (FXY | B-99) and the WisdomTree Emerging Currency Fund (CEW | C-45) have been rallying thanks to their exposure to nondollar currencies.

Currency-Hedged ETFs

The biggest theme in the ETF world in 2015 was currency hedging. Products that hedged international currency exposure were extremely popular last year, garnering billions in inflows.

They performed well, too, as the dollar climbed to new heights. As the buck was climbing, these ETFs, such as the WisdomTree Europe Hedged Equity Fund (HEDJ | B-47) and the WisdomTree Japan Hedged Equity Fund (DXJ | B-64), 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, expect investors to gravitate toward vanilla international ETFs at the expense of currency-hedged ETFs.

Related ETFs: GLD, IAU, GDX, UUP, EUO, FXE, FXY, CEW, HEDJ, DXJ

Contact Sumit Roy at [email protected].