Investing: Playing a Pullback in the Dollar

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Adam Boyton, G-10 foreign exchange strategist at Deutsche Bank (DB), thinks that over the next two to four years, currency movements will cease to be determined by just one factor such as relative economic growth. Instead, they will be influenced by a number of factors, including interest rate differentials, risk assessments, and current account deficits.

If equity markets continue to normalize, Boyton says he expects to see a much lower correlation between equities and currencies by midsummer. He and others predict the euro will top out at around $1.50 by the end of the summer before returning to a trading range between $1.30 and $1.50 for the rest of this year.

If you're bullish on the euro, the CurrencyShares Euro Trust (FXE) offers good exposure. With a net asset value of $589.8 million, the ETF's total return is -1.89% year-to-date as of May 20.

For a High Yield, Emerging Markets

Currency plays tend to be "an iffy proposition for ordinary investors just because predicting the direction of currencies is very difficult to do," says Gregg Wolper, a senior mutual fund analyst at Morningstar (MORN). "Even the experts get tripped up time and time again on their expectations of where currencies are going."

One way to avoid directional bets is by investing in a currency carry trade, which entails borrowing a low-yielding currency such as the yen and selling it to fund the purchase of a much higher-yielding currency. It's not possible to do such a trade within the G-10 currencies now, since their interest rates have all been sharply reduced to spur economic growth, says Boyton at Deutsche Bank. These days, to get a high yield, you have to borrow a G-10 currency and go long on an emerging-market currency, he says.

Carry trades are generally the province of institutional investors who are comfortable using more sophisticated instruments in their portfolios. There are two ETFs, however, that give retail investors access to a replicated carry trade—the PowerShares G10 Currency Harvest (DVB), which goes long on the three currencies with the highest yields and short on the three with the lowest yields.

When you invest in this ETF, you're essentially using two-times leverage since 100% of the fund's net asset value goes into both the long positions and the short ones, says Bradley Kay, an ETF analyst at Morningstar. He confirms, though, that the only place currently to find yields of any real size is in emerging markets.

Doubts About the Dollar's Status

The second carry trade vehicle is actually an exchange-traded note, or ETN, offered by Barclays (BCS)—the iPath Optimized Currency Carry (ICI). Some people are wary of ETNs because they are debt instruments that bear the credit risk of the sponsor, in this case Barclays Bank. But this ETN trades at a much smaller discount than usual since shares can be redeemed at any time instead of having to be held to maturity in 2038, says Kay.

Another distinctive feature of the iPath notes: The sizes of their long and short positions are changed periodically according to the volatility of each of the underlying currencies.

Over the longer term, there are doubts about the dollar's ability to withstand challenges to its status as the world's sole reserve currency. Those concerns gained some traction this week with the signing of 13 bilateral trade agreements between China and Brazil, with the goal of eventually being able to settle trades in their own currencies instead of the dollar.

"Contrary to speculation that circulated, there was no agreement of the invoicing currency for bilateral trade," Marc Chandler, a currency strategist at Brown Brothers Harriman, wrote in a note on May 19. "Talk of such an agreement was probably driven by a surge in Brazil-China bilateral [trade] in March and April, which caused it to surpass the amount of U.S.-China bilateral trade."

Decline in Influence

China has taken important steps toward a fully mature currency—creating swap lines with neighboring countries and developing its own derivative markets—but is "reluctant to dump a free-floating currency on its people because they don't want to cause disruptions to business," including the need to start hedging their currency risk, says Merk.

Although dumping the dollar as a reserve currency is in nobody's interest, least of all China, which holds so much U.S. government debt, most Asian countries are realizing they have been overly dependent on the U.S. market, says Merk. As they continue to develop their own markets, the dollar, at least on the margin, will decline in influence.

"That's good for the world economy but not very good for the value of the dollar vs. other currencies," he says.

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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