Mario Draghi is getting his wish. Back in August, the head of the European Central Bank (ECB) expressed a desire to see the euro lose value against the dollar. Since then, the dollar has rallied against the euro (and many other currencies) and most market strategists expect the dollar to strengthen further in coming quarters.
If they’re right, then investors need to start adjusting their portfolios to make sure they’re not caught in the currency crossfire.
The catalyst for an upward move in the dollar is no secret. “The U.S. economy is poised to keep growing faster than the European and Japanese economies, and central banks policies are diverging,” says Russ Koesterich, chief investment strategist at BlackRock.
Indeed, both the ECB and the Bank of Japan are now planning their own stimulus measures, modeled after our own quantitative easing programs, which should last well into 2015. This comes right at a time when our QE program is winding down.
In anticipation of that scenario, billions of dollars (and euro and yen) are flowing away from economies with falling interest rates and towards economies with rising interest rates. The ECB’s Draghi “would probably like to see the dollar/euro rate fall to around 1.20,” notes WisdomTree research director Jeremy Schwartz, adding that such a target may prove conservative considering that the U.S. Federal Reserve hasn’t even started hiking rates yet. For a bit of context, one euro bought roughly $1.40 this past spring and currently buys around $1.30.
So how will a rallying dollar impact various asset classes? It’s bad news for commodities such as oil, according to Marc Chandler, global head of currency strategy at Brown Brothers Harriman. Commodities are priced in dollars, and global investors will reduce their purchases as their own currency weakens.
And gold bugs may be in for a tough slog. “If the Fed is tightening, the opportunity cost of holding non-interest bearing assets such as gold goes up,” says Chandler.
As a silver lining, U.S. bonds may rally (pushing down their yields) as import prices fall in tandem with weaker euros and yen. “This is another reason to think that inflation won’t accelerate,” says BlackRock’s Koesterich. For U.S. stocks, the benefits are less clear-cut. U.S. exporters will face a tougher operating environment as foreign rivals seek to take advantage of the currency changes and undercut them on price.
If the dollar does get stronger, perhaps the greatest impact for U.S. investors may come in the form of foreign stock and exchange-traded fund ownership. A weakening euro and yen can reduce the value of foreign holdings, which is why many investors have begun to explore the role of currency-hedging ETFs. They come in two flavors: direct currency arbitrage funds and currency-hedged equity portfolios.
An example of the first kind of ETF is the PowerShares DB US Dollar Index Bullish Fund (UUP), which already has rallied roughly five percent thus far in the third quarter, and is poised to move yet higher as central bank policies start to diverge. This ETF carries a stiff 0.75 percent expense ratio, and should really be viewed as a portfolio hedging tool, rather than as a vehicle for potentially robust upside.