Investing May 20, 2009, 10:26PM EST

Investing: Playing a Pullback in the Dollar

Some investment pros are predicting the euro will rise to $1.50 this summer. Here are funds and ETFs to consider

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With signs of improving economic conditions worldwide, investors are once again starting to consider higher-risk vehicles such as currencies.

On May 20, the euro reached US$1.3831, its highest level vs. the greenback since January, while the British pound achieved a six-month high of $1.5760. The spark for the mini-rally: a combination of encouraging remarks by Timothy Geithner about improving credit markets and signals that Fed officials are willing to raise the mortgage and Treasury bond purchasing programs beyond the $1.75 trillion the Fed has already agreed to buy, according to Action Economics.

The 10-week rebound in equity indexes around the world has sped the dollar's retreat against the euro and other key foreign currencies. Many strategists agree that the greenback's strength peaked last year on flight-to-quality buying of Treasury notes by investors worldwide who were terrified of all other asset classes.

If the buck is set to pull back, with some pros saying the euro is heading to $1.50 over the summer, which funds or ETFs should you play?

Axel Merk, who manages the $280 million Merk Hard Currency Fund (MERKX) is bullish on the euro and bearish on the dollar, because the European Central Bank's policies are less inflationary than those of the Federal Reserve. The ECB has taken heat for being slower to cut interest rates in response to the economic crisis and its economy will be slower to recover than the U.S. economy. But at least Trichet & Co. won't have sacrificed long-term currency stability for that growth, he says.

Euro as Stability Play

"The Fed's focus is to support price stability and if it's not doing that then it's not living up to its mandate," he says. "Price stability is the key ingredient to get long-term growth. The Fed is fudging that concept these days. In the best-case scenario, we'll get inflation growth in the U.S."

And instead of encouraging private-sector investment, the Fed's programs are substituting for it, he adds.

Contrary to popular perception, a country doesn't need economic growth to have a strong currency, he argues. It only needs to be growing its economy when it has a current account deficit, as the U.S. does. From that perspective, the worst thing that can happen to the U.S. would be a more consistent flow of positive economic news since that would revive inflation fears, which will reduce demand by foreign investors for U.S. Treasuries, causing the dollar to sink further. That would also raise the cost of credit for U.S. businesses and consumers and push the economy back into recession, he says.

The Merk Hard Currency Fund currently has 49.4% of its exposure to the currencies of Western Europe, with a 23.7% weight in the euro specifically. The fund doesn't own any British pounds or Swedish krona at the moment. The fund was down 0.8% year-to-date as of Apr. 30.

For Merk, the euro is a stability play, while the so-called commodity currencies in markets like Brazil and Australia are reflation plays. All the money being printed by the central banks of the Group of 10 industrialized nations will ultimately be used to buy commodities such as oil and metals, which offsets the higher volatility in those currencies, he says.

Dollar: Short-Term Weakness

Meg Browne, senior currency strategist at Brown Brothers Harriman, is pegging her expectations for the dollar's long-term strength on the difference in economic growth between the U.S. and other regions such as the euro zone. But in the shorter term she believes the greenback will stay weak as investors continue to anticipate economic recovery.

She doesn't share Merk's concerns about Treasuries when a more sustained economic recovery comes since she thinks people will shift back into stocks slowly. In the meantime, the Fed will have made progress unwinding some of the debt positions it took on as part of its liquidity programs, she says.