The US Dollar has been in decline against the currencies of its key trading partners since January 2002. It takes considerably more Dollars to buy the basket of key currencies than it did in January 2002, but only slightly fewer than it took in January 1995.

What is in the Dollar Index?  The Atlanta Fed index is based on 1995–97 bilateral trade weights for 15 currencies. The European subindex includes the European Monetary Union, Switzerland and the United Kingdom. The Pacific subindex includes Australia, China, Hong Kong, Japan, Malaysia, Singapore, South Korea and Taiwan. The Americas subindex includes Brazil, Canada and Mexico. The overall dollar index includes the Saudi Arabian riyal along with the foregoing 14 currencies.
 

So, where does the Dollar index go from here?  Opinions are strongly divided as recent extra volatility in the FX market has shown.

You can place your bet on the US Dollar index with futures contracts, or with one of two ETFs (UUP for a rising Dollar, or UDN for a falling Dollar).

Is the current situation terrible, because the dollar has fallen so much in the last 6 years - or was the situation in 2002 an artificially high period for the Dollar?

In this week’s Barrons, Carl Weinberg, Chief Economist of High Frequency Economics predicts that the Dollar will rise when the Fed stops cutting and begins raising interest rates. 

Certainly, interest rate differentials between currencies and the direction of interest rate changes have strong impact on exchange rates. Mr. Weinberg may be correct that the Dollar will rise when rates rise again, but we think it would be dangerous to make a currency bet on that parameter alone.

Consider the chart below that shows the history of the Fed Funds rate over the period from 1995.  It would be quite difficult to draw a cause and effect relationship between Fed Funds rates and the exchange value of the Dollar when you compare their charts.

There are other important issues; including trade balances, inflation rates, real interest rates (nominal rates less inflation), macro-economic reports, geo-political risks, relative central bank rates between countries, and the expectations of speculators who dominate the key exchange markets. 

Crisis and panic as we have seen in the credit market as of late, have a significant impact on exhange rates.  For example, the FX market lurched in both directions in the days surrounding the Bear Stearns collapse and the coping moves made the the Fed.

Exchange rates are a matter of supply and demand of currency pairs.  Many factors drive supply and demand.

US Dollar Index Trade Weighted Components:

Investors have single currency access to the six most important currencies in the US Dollar index through these ETFs or ETNs:

• FXE (Euro)
• FXC (Canada)
• CNY (China)  - etn
• FXM (Mexico)
• FXY (Japan)
• FXB (United Kingdom)

ETFs pay distributions and ETNs do not.  ETNs incur imputed income tax liabilities according to a recent IRS ruling.

The US Dollar, the Euro and the Yen are most important currencies in the foreign exchange markets by trading volume.  Foreign exchange volume is over $2.5 Trillion per day, and is greater in value than the sum of all other investment markets, including stocks, bonds, real estate, and commodities.

Major reserve surplus countries are beginning to diversify their liquidity into multiple currencies.  Doing the same with individual liquidity reserves could make sense in some cases.  Today there are several vehicles for investors to accomplish currency diversity, if they seek it.

Richard Shaw
QVM Group LLC

We recommend holding a diversified basket of currencies in the liquidity portion of a portfolio for experienced investors.

The Dollar just can’t seem to do anything right recently. The EURO is as expensive as it has ever been for those of us based in US Dollars. It takes far fewer Japanese Yen to buy a Dollar than not long ago.

Major currency reserve surplus countries, the largest of which is China, are taking action or talking about taking action to diversify their currency reserves beyond Dollars — reducing demand for Dollars.

Some oil producing countries are considering pricing oil in other currencies, Russia being at the front of that line.

Investors and currency traders see falling US interest rates relative to other major currencies, creating negative carry or reduced carry for being long Dollars.

Then there are the concerns about US deficits.

All of these things have been squashing the Dollar, as the following forex charts show.

The EUR/USD shows it now costs over $1.50 to buy one Euro. It was once less than $0.90.

The USD/JPY chart shows that it takes only about 105 Yen to buy $1.00, compared to approximately 124 Yen to buy $1.00 less than a year ago.

These changes in the exchange value of the Dollar have huge impacts on corporate results — who or what wins and who or what loses. Companies most able to manage their currency exposure by financial or operational means will fare best.

Even though we all have currency risk no matter what we do — whether we do nothing or do something — we think taking direct currency exposures within the liquidity portion of a portfolio makes sense.

You can create and manage currency exposure as an investor or trader through forwards, spot forex, currency futures, futures based funds and trusts or funds that hold bank deposit accounts in different currencies.

You can be exotic with minor currencies, but a reasonable approach would involve the three key currencies (U.S. Dollar, Japanese Yen and Euro).

For ourselves, we prefer to use spot forex positions due to the lower costs compared to investment funds of any type. Currency forwards are even less costly, but take a lot a capital. Spot forex has no management fee and very low bid-ask spreads for major currencies.

For spot forex you would open a forex account with a major bank such as Deutsche Bank. We would urge you not to open an account with a forex broker. Forex accounts are not insured, and you want the most substantial institution to hold your funds that you can find.

Minimum positions for spot forex can be too much for some investors, and there is an inconvenience factor of having a separate account and the associated paper work. There is no term or expiration on forex positions which roll over daily and earn bank overnight rates.

You could trade in currency futures, but that can be expensive and you need to roll your positions which is an administrative burden and a repetitive expense. That involves a separate account too.

For those who are willing to incur the substantially higher costs of bid-ask spreads and fund management expenses, but with the convenience of using existing stock brokerage accounts, there are ETFs and ETNs to consider.

The currency ETN’s (ERO for the Euro, and JPY for the Yen, for example) no longer present the tax advantage they once held out as available, and they do have counterparty risk, so we’d avoid them.

The currency ETFs, are of two types:

• Trusts that hold the currency in bank deposit accounts and payout monthly (FXE for the Euro, and FXY for the Yen, for example). Between the 40 basis point expense ratios and the bid-ask spreads, these represent an expensive option.

• Entities that invest in currency futures (UUP for a Dollar bullish position, or UDN for a Dollar bearish position) invest in futures that are based on the US Dollar Index, which is a trade weighted index of the key currencies with which the US has international trade. They too have bid-ask spread costs and an approximate 55 basis point expense ratio.

There are some taxation issues to consider that are beyond the scope of this article and on which we are not qualified to advise. There is a helpful website you might want to consult for background before you ask you own tax adviser which of two basic options to elect for taxation of your currency investments (run by Green Company CPA’s).

We recommend considering currency positions within the liquidity allocation of portfolios for experienced investors.

Richard Shaw
QVM Group LLC

Currency effects on investments are important and probably not appreciated enough by most investors.

If you have a conviction about the direction of the US Dollar, you can power boost your general equity returns by exposing your portfolio more or less to domestic or foreign stocks. If you don’t have a conviction, you are still likely making a currency bet, when you chose your balance of domestic and foreign stocks or stock funds.

Analyzing the results of a multi-company foreign index from the top down can give a fairly clear view of the effect of currencies on index performance, as the table below shows.

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The 3, 5 10 and 15 year annualized returns of the Russell 1000 (proxy IWB) is shown in US Dollars. The MSCI World ex US (proxy VEU), the MSCI EAFE (proxy EFA), the MSCI Europe (proxy IEV) and the MSCI Japan (proxy EWJ) indices are shown for the same periods in both US Dollar denominated returns and in local currency denominated returns – all but Japan involve multiple currencies weighted according to the weight of each country in the index.

The difference between the US Dollar denominated return and the local currency denominated return measures the effect of currency exchange rate changes from the perspective of US Dollar based investors.

For example, the table shows that the return experienced by US investors who invested in the developed and emerging markets of the world excluding the United States should attribute ¼ to ½ of their return to currency effect – the decline of the US Dollar against those other currencies in this case.

You can also see that the relative strength of the US Dollar depressed the Dollar denominated returns of EAFE investments over 10 and 15 years, and over 3 years for Japan investments.

Let’s flip it around now and see how investors based in other currencies experienced returns investing in the United States, as exemplified by the Russell 1000 (the largest 1,000 U.S. public companies).

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You can see that developed world, non-US Dollar investors did better in the U.S markets over a 10 and 15 year period due to a rising Dollar. They did less well over 3 and 5 years due to a falling Dollar. Only the Japanese, in these examples, have benefited by currency effects during the past 3 years when investing in the U.S. stock market.

On average U.S. investors and foreign investors have done better recently by investing outside of the United States. A significant part of the that benefit comes from growing relative strength of other currencies.

There are products that allow investors to take direct currency exposure such as futures accounts, FX accounts, and a growing number of currency ETFs and ETNs (such as UUP, UDN to bet on the direction of the Dollar against a trade weighted basked of currencies; FXE and ERO to hold the EURO; and FXY and JYN to hold the Japanese Yen), but few investors would commit large allocations to those products. Yet, investors make large currency related allocations, often unknowingly, when they decide how much of their equity portfolio will be in US stocks versus foreign stocks.

You really need to consider the currency issue when you design your portfolio holdings and allocations.

Richard Shaw
QVM Group LLC

Disclosure: Author owns VEU.