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

By David Bogoslaw

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.

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.