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Surging US Dollar Impacting ETFs

Sumit Roy

Economic worries are causing U.S. interest rates to tumble, but that hasn’t hurt the U.S. dollar. The greenback is still one of the strongest currencies around, and has been trading at close to the highest levels in two years.

Year to date, the $380 million Invesco DB U.S. Dollar Index Bullish Fund (UUP), which tracks U.S. Dollar Index futures, is up 3.4%, adding to last year’s 7.1% gains.

 


US Dollar Index

 

Rates Plunging Faster Elsewhere

There are a few reasons the buck may be holding up despite plunging U.S. interest rates. For one, even after their decline, U.S. interest rates are well above the rates seen in other developed countries. The German 10-year bond yield, for example, hit a record-low of -0.2% last week (yes, negative 0.2%), falling below the previous lows set in 2016.

In Japan, the equivalent 10-year yield is at -0.1%, and in the U.K., where rates are actually positive, the 10-year is still only yielding 0.89%.

Compare that to the U.S., where the 10-year Treasury is yielding 2.12%. Sure, it’s the lowest yield in 21 months, and certainly, it could head even lower if the Fed cuts interest rates a few times this year, as some traders expect. That doesn’t change the fact that U.S. rates and the U.S. economy (as uncertain as its outlook currently is) are still superior to the alternatives out there.

Straightforward Impact

For ETF investors, the dollar’s strength has repercussions, both direct and indirect. The most straightforward impact is on currency ETFs like the aforementioned UUP, or the Invesco CurrencyShares Euro Trust (FXE), the Invesco CurrencyShares Japanese Yen Trust (FXY) or the WisdomTree Chinese Yuan Strategy Fund (CYB).

ETFs with long exposure to the dollar have been doing well, while ETFs with long exposure to rival currencies have been performing poorly. Currency ETFs are good tools for investors to bet on that trend continuing or reversing.

Exporters Affected

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 stronger dollar makes U.S. exporters less competitive and reduces the profits of multinational companies that conduct much business overseas.

The iShares Russell 1000 Pure U.S. Revenue ETF (AMCA), which hardly holds any exporters, only focusing on stocks of companies that derive 85% or more of their revenue from the U.S., recently began outperforming the S&P 500. It’s not by much, but if the buck strengthens even more, especially as trade war concerns persist, that could fuel further outperformance in AMCA.

Similarly, small cap stocks, such as those held in the iShares Russell 2000 ETF (IWM) tend to have less overseas exposure than the large cap stocks held in the SPDR S&P 500 ETF Trust (SPY). That hasn’t really helped IWM this year—it’s underperforming SPY by a tad—but it could if the dollar becomes a bigger factor.

 

YTD Returns For SPY, IWM, AMCA

 

Currency Hedging

Another area where currencies play a big part is with international equities. 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 Xtrackers MSCI EAFE Hedged Equity ETF (DBEF), the WisdomTree Japan Hedged Equity Fund (DXJ), the WisdomTree Europe Hedged Equity Fund (HEDJ) 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).


​Email Sumit Roy at sroy@etf.com or follow him on Twitter @sumitroy2

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