Saturday, May 7, 2011

Betting against the dollar useful for diversification

Saturday, May 7, 2011

If youve been to Europe lately, you know that $20 will get you a croissant, a cup of coffee and a pitying smile. The greenback has taken a pounding on the currency markets this year.

  • A currency exchange in Milan, Italy.

    By Luca Bruno, AP file

    A currency exchange in Milan, Italy.

By Luca Bruno, AP file

A currency exchange in Milan, Italy.

Whats bad for U.S. tourists, however, is good for U.S. investors: A weak dollar amplifies gains from foreign investments.

If you bet against the dollar, youd be in good company: The dollar is nearly universally hated by investment advisers. But plenty of people have gone bust betting against the buck. If youre going to invest in currencies, buy a broadly diversified basket and use it for just that: diversification.

The St. Louis Federal Reserve bank tracks a basket of currencies against the U.S. dollar. Its trade-weighted dollar index sits at 96.32, within a whisker of its 10-year low, set in the depths of the 2008 financial meltdown.

A year ago, $10 would buy 7.30 euros. Today, $10 buys 6.90 euros, which is why U.S. tourists are bringing their own food when they go to Paris.

But the falling dollar is a wonderful thing for U.S. investors. Lets say you owned 1,000 shares of MooseCo, a fictional European hatrack maker. Every quarter, you got a dividend check from MooseCo for 100 euros. When you cashed your check a year ago, you got $137. When you cashed it Wednesday, you got $145. Although your dividend payout didnt change, converting euros to dollars netted you a 6% increase.

The dollar has been taking a dive for several reasons, most of which can be traced to the Federal Reserve. The Fed controls short-term interest rates. In an effort to keep the economy from slipping back into recession, the Fed has pushed short-term rates to nearly zero. And through its $600 billion round of buying Treasury securities, the Fed has pushed down longer-term rates, too.

Money usually flows to where it can get the highest returns. Currently, a three-month T-bill yields 0.06%, vs. 0.83% for a German three-month bill. Lower rates make it more attractive for banks to lend, because it increases the spread between what banks pay for money and what they charge to lend. Lower rates also drive money into other types of assets, such as stocks: Anything looks appealing compared with a 0.03% money fund yield.

By driving down rates, the Fed has also pushed the dollar down, which makes U.S. exports more attractive abroad and imports more expensive.

The question, then, is whether the dollar will start to rise. The chronic deficit argues for a lower dollar in the long term, says Axel Merk, manager of the Merk Hard Currency fund. The absolute deficit is not a good predictor of the exchange rate, Merk says. What is relevant is whether it finances it from foreigners. Japans huge deficit, for example, is largely financed by the Japanese; the U.S. relies on foreigners to buy its debt.

But dont think that a currency play is a sure thing: far from it. If the economy recovers, interest rates will rise, and that, in turn, could boost the dollar. A workable plan to trim the deficit over time could do the same. Hey, you never know.

Currency speculators tend to lose early and often, and the mutual fund industry gives you plenty of ways to speculate on currencies. To use a technical term, many of these vehicles are stupid. Theres no reason on Earth, for example, that an average investor should buy the ProShares Ultra Euro, which uses futures and options to gain 2% when the dollar gains 1% vs. the euro, and vice versa. You probably dont need the CurrencyShares Russian Ruble Trust, either.

But there is one reason to buy a broad-based currency fund: diversification. The Trade-Weighted Dollar index, for example, tends to rise when the stock market falls, and vice versa. A small position in a diversified currency fund could help to offset losses in the stock market. Like any hedge, however, it can also detract from your gains in an up market.

Currency funds are relatively new; the three leaders in the chart are actively managed, but highly diversified. The PowerShares DB G10 Currency Harvest (ticker: DBV), despite its slightly goofy name, has an interesting strategy, overweighting positions in currencies of countries with high short-term interest rates.

A currency fund probably wont get you a trip to Paris. But it might help keep your portfolio from heading too far south.

John Waggoner is a personal finance columnist for USA TODAY. His Investing column appears Fridays; for more of his columns go to His book,Bailout: What the Rescue of Bear Stearns and the Credit Crisis Mean for Your Investments, is available through John Wiley & Sons. John's e-mail is Twitter:


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