Why Dollar's Falling With Bond Yields Surging

How the greenback recently hitting three-year lows impacts investors.

The U.S. economy is heating up, and consumers are the most confident they’ve been since the year 2000. It’s a bit puzzling then that the U.S. dollar recently made headlines for falling to a three-year low.

The greenback is already 3.5% lower than where it started 2018 and 14% below its peak of last year.

Why is the buck falling if the U.S. economy is doing so well?

It could be because, as impressive as growth in the U.S. has been recently, economies elsewhere are performing even better. Earlier this week, it was reported that the 19-member eurozone economy expanded by 2.5% in 2017, the fastest rate since 2007, and ahead of the 2.3% expansion the U.S. saw last year.

The good news has prompted speculation that the European Central Bank could end its quantitative easing program sooner rather than later. The ECB cut its monthly bond-buying pace in half to 30 billion euros starting in January.

A Reuters survey of economists showed 90 % of them predicted the central bank will end the program completely by the end of the year, with a sizable number of respondents anticipating an end to QE as early as September.

Key Factors

Economic growth, interest rate differentials and inflation are three factors that drive currency movements, according to Kevin Flanagan, senior fixed-income strategist at WisdomTree.

Most of those factors are working in favor of the euro, which is the dollar’s biggest rival, making up 58% of the widely followed U.S. Dollar Index. The surprise factor (that few anticipated Europe to be doing as well as it is) is also spurring the euro higher against the dollar.

On the monetary policy side, the potential end of the ECB’s massive QE program is seen as more significant than the likely two or three rate hikes by the Fed this year, which is another boost for the euro.

It’s not just Europe. Japan is also in the midst of a strong expansion, with GDP growing for a record-setting seven-straight quarters through last September, putting pressure on the Bank of Japan to tighten the monetary spigots, as other central banks have done.

Meanwhile, emerging markets are forecast to grow at their fastest pace in five years in 2018―4.9%, according to the IMF―adding fuel to the fire in emerging market currencies. The WisdomTree Emerging Currency Strategy Fund (CEW), which tracks a basket of 15 EM currencies, is up 2.9% already this year on top of last year’s 11.1% gain.

Bigger Picture

It’s important to put the dollar’s latest decline into perspective. For three-straight years—between 2014 and 2016—the greenback surged higher as the Fed ended “QE3,” the stimulus program that had the U.S. central bank buying as much as $85 billion worth of government bonds per month, and did away with the zero-interest-rate policy that was in place since the financial crisis.

The Fed began tightening monetary policy just as other central banks were loosening theirs (the ECB began its QE program in 2015). The relatively hawkish policies of the Fed compared with other central banks pushed the U.S. Dollar Index to a peak of just under 104 on the first trading days of 2017, the highest level for the index since 2002.

The recent decline in the dollar is coming off those lofty levels; the U.S. Dollar Index is still trading more than 10% above where it was when the post-QE3 run began in 2014, and more than 25% above the low of the past decade (set in 2008).

US Dollar Index

Direct Currency Bets

That context is important because it helps investors understand where the dollar is trading historically. It’s not high or low; it’s right around its average level of the past two decades.

With that said, what should an investor to do when it comes to currencies? The most aggressive option—only appropriate for active traders—is to take a directional bet on the dollar.

One predominant view is that the buck will continue to weaken as international economies outperform the U.S. and central banks like the ECB tighten monetary policy fairly aggressively. The opposing view is that the U.S. economy outperforms, with GDP growth handily outpacing 3%, leading to faster inflation, faster Fed rate hikes and a stronger dollar.

Whatever you view, there’s plenty of ETFs available to make those direct currency bets.

In addition to the aforementioned CEW, there’s the PowerShares DB U.S. Dollar Bullish Fund (UUP), which provides inverse exposure to the U.S. Dollar Index; the CurrencyShares Euro Trust (FXE), which targets the euro; the CurrencyShares Japanese Yen Trust (FXY), which goes long the yen, and many more.

Indirect Impacts

Even for investors who aren’t interested 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 weaker dollar makes U.S. exporters more competitive and boosts the profits of multinational companies that do a lot of business overseas.

Large-cap stocks, such as those held by the SPDR S&P 500 ETF Trust (SPY), tend to have more exposure to those types of companies than the domestic-focused small-cap stocks of the iShares Russell 2000 ETF (IWM).

Meanwhile, 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 WisdomTree Japan Hedged Equity Fund (DXJ), the WisdomTree Europe Hedged Equity Fund (HEDJ), the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) 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