Don Dion
Don's Investment Newsletter: Don's Asset Management Business:
After suffering a long-term slump, the dollar rose more than 8% this past month in relation to the euro, leaving investors wondering how to participate in the upswing. Currency investing has always been a volatile and risky arena—and ETF issuers have released a slew of ETFs in the past two years that allow investors exposure to different currencies. In 2006, PowerShares launched two alternatives to direct currency futures investment in the U.S. dollar: PowerShares DB US Dollar Index Bearish (UDN) and PowerShares DB US Dollar Index Bullish (UUP).
UDN benefited from the dollar decline earlier this year—rising more than 7% from January 2 to March 19. In the last month, however, the dollar—and subsequently UUP—has experienced a sudden comeback. While the dollar index wavered Monday only to finish the day unchanged, the question now is: Is the rally over, or does UUP still have the potential to continue its upswing? The recent moves in both UUP and UDN have bolstered the funds on our Currency Momentum Table and relative to equity funds overall. UDN shifted from the 17th position on July 9 to the 10th position on August 20, while UUP moved from the 29th to the 9th spot for the same period.
UDN and UUP are designed to give investors exposure to the direction of the dollar, through long (UUP) and short (UDN) futures bets using futures contracts tied to the U.S. Dollar Index. This index measures the dollar against a basket of six other currencies: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. On July 15, the U.S. Dollar Index closed at 71.87—the lowest value since April’s record lows—and then suddenly reversed course.
While many analysts have been calling the bottom for months, the momentum of this reversal is somewhat unexplained by the normal course of economic news. While financials have experienced a rally, a dark cloud of speculation remains over the sector. Similarly, concerns surrounding both Fannie (FNM) and Freddie (FRE) and the U.S. deficit are ongoing, causing many to believe that the worst is yet to come.
One explanation for this rally is recent dollar intervention and changes in the U.S. International Reserve Position. The U.S. Treasury website recently reported that the Exchange Stabilization Fund sold 10 billion euros and bought dollars, a move that certainly strengthened one currency against the other. It is difficult to claim that measures like this could sustain a dollar rally—the foreign exchange market is the largest in the world, and broad measures by international banks might be curbed by inflation worries abroad.
So could currency intervention be enough to cause, or sustain, a true rally in the dollar and UUP? Other possible causes of a reversal are the price of oil and falling demand in U.S. markets. In an interview on August 8, Marc Faber noted: “As a result of weak demand in the U.S. and lower imports, the demand for oil declined, and that led to a tightening of global liquidity, which led to the strong dollar.”
Since UUP effectively invests long in the dollar against the six currencies in the Deutsche Bank U.S. Dollar Index, economic news both within the U.S. and abroad is crucial in determining the returns of the fund. The latest Inflation Report from the Bank of England caused a great deal of speculation about lower interest rates and an economic recession, as sterling has fallen to the lowest levels since 2006. The news from Japan has not been rosy either—the Japanese GDP was down an annualized 2.4% for the second quarter. Finally, the ECB signaled an end to rate hikes earlier this month, and many expect rate cuts to begin later this year, which would make American interest rates more competitive with those in Europe.
As a result, the U.S. dollar had its largest single-day gain in several years and the euro experienced its largest single-day loss since the beginning of the decade. This downward pressure felt throughout the countries that comprise the U.S. Dollar Index may indeed be long term—a trend that could help UUP maintain its momentum in the months to come.
In addition to measuring the strength of the dollar against the basket of global currencies, both UDN and UUP are collateralized with three-month U.S. Treasury bills, which provide additional income to fund investors. This strategy has been successful since the inception of the funds—softening the downside for whichever fund is on the wrong side of the dollar news.
Faber cites the relative prospects for the dollar—and the prospect of future rate cuts abroad—as his reason for being long the U.S. dollar, but not long U.S. equities. “Relatively speaking, the U.S. economy is in better shape because of the weak dollar,” he said. “My view was that after four years of under- performance in the U.S. compared to Europe, the U.S. would now outperform for three to six months, and I still maintain that.”
If Faber is right, the prospects for UUP could re- main positive for the rest of 2008 and the beginning of 2009. While betting on currency movement is made difficult by the variety of factors that impact relative strength, UUP could be a good addition to aggressive portfolios for the near term—and a good hedge against international exposure for conservative investors in the months to come.
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