Is the Euro Headed for a Break Up?

• By ETFguide.com
• On 11:04 am EST, Friday January 30, 2009

SAN DIEGO (ETFguide.com) - What's up with the euro dollar? Or, maybe the better question is what's down with the euro?

This global currency has been weakened by declining interest rates that's driven it on a swift downward spiral. The euro recently traded at seven-year lows versus other leading currencies like the Japanese Yen.

Two weeks ago, the European Central Bank (ECB) lowered its benchmark borrowing interest rate to 2 percent. Not only is this the lowest rate on record, but more rate cuts are likely as the ECB aims to combat a sharp downturn in economic activity.

Economists are predicting that Europe's economy will contract by 1.5 percent to 2 percent in 2009.

As the global economic situation continues to dim, a number of euro-zone countries like Greece, Portugal, and Spain have seen their sovereign credit ratings cut. This raises borrowing costs and creates even further financial strain on these countries. Could their financial problems become everybody else's?

'The Euro area is demonstrating just how dangerous it is to impose currency union on economies and markets that had not properly converged in the first place,' observes John Redwood Chairman of the Economic Competitiveness Policy Group

Redwood noted, 'The cost of borrowing money has risen for the governments of the weaker economies of the Union, despite the fact that they are all part of the same currency area with some implied obligations from the stronger to the weaker members.' He added, 'The bond markets are becoming more suspicious of the sovereign debt of the heavy borrowers amongst the Euroland governments, placing a risk premium on their money raising.'

What would happen to the euro if any of its members defaulted on their country's sovereign debt? It could leave bond holders absorbing multi-billion losses which would create a ripple affect to other euro-zone countries. It would also negatively impact the euro's reputation and lead to higher borrowing costs for other member nations. 

Legendary investor and perennial commodity bull Jim Rogers recently told the UK paper METRO that he believes the euro won't endure the test of time. 'I'm not so sure the euro will last,' Rogers said.

Other well-heeled investors haven't been shy about their view of the euro's future either.

George Soros said the euro might not survive without a coordinated and global plan. Soros has challenged the European Union to formulate a solution to the address the toxic debt on the balance sheet's of Europe's banks.

Proponents for the euro argue that being a member of a larger currency bloc gives countries some protection against market tornadoes like those that have overtaken Iceland. Also, the European Union has taken decisive action to prevent the economic woes of other European countries not part of its union from spilling over. Last year it contributed $20 billion along with the International Monetary Fund to aid Hungary.  

The ECB is responsible for the monetary policy of 16 euro-zone countries. The Frankfurt, Germany-based alliance has member nations that include Austria, Belgium, Cyprus, Finland, France, Ireland, Italy, Germany, Greece, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia, and Spain.

Here's a quick glance at key currency ETFs linked to the euro:

CurrencyShares Euro Trust (NYSEArca: FXE - News) -7.22% (YTD Return)*

Launched in December 2005, this ETF seeks investment results that correspond to the euro Noon Buying Rate. This product is designed to track the price of the Euro net of Trust expenses, which are expected to be paid from interest earned on the deposited Euros. Interest that exceeds trust expenses is distributed monthly. 100 is the number of Euro per share. In 2008, FXE had a modest decline of 1.65%. The fund's annual expenses are 0.40%.

ProShares Ultra Euro (NYSEArca: ULE - News) -14.51% (YTD Return)

Just launched in November of last year, (along with the other ProShares ETF mentioned below) this is the ETF you'd want to own if you're bullish on the future prospects of the euro. It aims to deliver twice (200%) the daily performance, before fees and expenses, of the euro. The fund operates as a partnership under the Securities Act of 1933. The fund's annual expenses are 0.95%.

ProShares UltraShort Euro (NYSEArca: EUO - News) +13.78% (YTD Return)

This is the ETF you'd want to own if you're bearish on the future prospects of the euro. It aims to deliver twice (200%) the inverse (opposite) daily performance, before fees and expenses, of the Euro. The fund operates as a partnership under the Securities Act of 1933. EUO's annual expenses are 0.95%.

WisdomTree Dreyfus Euro Fund (NYSEArca: EU - News) -5.20% (YTD Return)

Don't let the name of this ETF fool you. This fund is less of a currency ETF and more of a short-term bond ETF because it aims to earn current income reflective of money market rates within the European Union. The fund invests primarily in very short term, investment grade money market securities denominated in euros. Eligible investments include short-term securities issued by European governments and their agencies or instruments that are denominated in euros. EU uses a traditional open-end ETF structure and is an actively managed fund not hinged to a benchmark. EU's annual expenses are 0.35%.

Euro ELEMENTS (PCX: ERE - News)

This is an exchange-traded note (ETN) linked to the performance of the DB EUR Overnight Index. Generally, if the euro appreciates relative to the U.S. dollar, the value of Euro ELEMENTS will increase and vice versa. If the index does not appreciate, no distribution will be paid. Like all ETNs, this one carries credit issuer risk and is back by Deutsche Bank AG. The annual expense ratio is 0.40%.

Are Currency ETFs Right for You?

Many investors don't realize it, but they already have currency diversification. In fact, you automatically get this when you buy an international stock or bond index ETF. Virtually all of these funds offer unhedged exposure to foreign currencies, which isn't always true of actively managed mutual funds. Any strength in the value of foreign currencies along with corresponding weakness in the U.S. dollar is offset by owning internationally focused ETFs.  

Another factor to consider is taxes. Currency ETFs are usually structured as partnerships or grantor trusts. Profits generated from the trust distributed to shareholders are taxed as ordinary income. This means the long-term capital gains rate that applies to stocks does not apply to currency ETFs. Also, because of the WisdomTree ETF mentioned above is taxed in the same fashion as bond funds.

Are currency ETFs right for you? It's important to understand the full spectrum of facts before you decide to buy a currency ETF or ETN. We encourage you to learn as much as you can and use ETFguide's Profit Strategy Newsletter to help you sift through the currency maze.

*YTD Performance through market close of January 29, 2009

Buzz up!