Three ways to take on the falling US dollar

Many analysts suggest a structural downtrend in the greenback may well be underway, having started after the COVID-19 market sell-off. From its March coronavirus panic high, the US dollar has fallen around 30% to 31 July against the Australian dollar.

There are several reasons why there is pressure on the US dollar. The US Federal Reserve has been one of the most aggressive central banks with its quantitative easing (QE) program, which has dramatically boosted the supply of US dollars. Real yields on 10-year treasuries have collapsed below zero making US bonds and thus the greenback less attractive to investors.

This has led to a lack of confidence in the US dollar. In addition, as the coronavirus has spread throughout the world’s largest economy, the US has contracted at an unprecedented rate. In the June quarter in 2020 it shrunk by 32.9%, the largest quarterly decline since the series began in 1947.¹Clashes with China and an upcoming US election are also raising anxieties. On top of that, indications of a pickup in global economic activity has pushed investors into riskier assets and into emerging economies, further weighing on demand for the dollar. 

Below we describe three strategies investors can utilise when the world’s most traded currency is falling in value.

1. Currency hedging

For investors that invest in US assets, the decision whether to hedge your currency exposure for these assets is an important one, as movements in the US dollar versus the Australian dollar can either erode or add value to your investments. If, for example, the Australian dollar rises 10 per cent against the greenback, all other things being equal, the value of your offshore investments would fall by 10 per cent when assets are converted back into local currency. Movements in the currency can therefore have a big impact on your returns from international share investments. Hedging can play a part if you are a conservative investor and simply don’t want to expose yourself to any currency volatility.

Think about VanEck’s quality international equities ETF ‘QUAL’ (VanEck Vectors MSCI World ex Australia Quality ETF) which has around 70% of its investments in the US. QUAL is unhedged, so as the Australian dollar jumped off its US55 cents March low to be around around US72 cents at the end of July, that 30% gain would have adversely hit the value of QUAL’s US investments.

‘QHAL’ (VanEck Vectors MSCI World ex Australia Quality (Hedged) ETF), on the other hand, would have benefited from the Australian dollar’s relative strengthening. QHAL is a hedged version of QUAL. Hedging makes good sense if you think the Australian dollar is going to rise further.

2. Gold miners

Gold is traditionally used by investors as a hedge against the US Federal Reserve. The US dollar can lose value at any time if investors lose confidence in the US Fed, which is exactly what has happened during the coronavirus pandemic. As American political satirist and journalist P. J. O'Rourke describes it: “A US dollar is an IOU from the Federal Reserve Bank. It's not backed by gold or silver. It's a promissory note that doesn't actually promise anything.”  

Reflecting gold’s appeal in a time of crisis, it has jumped beyond US$2,000 in August, its highest ever price. Bullion’s quick move higher in recent weeks has come amid negative real rates in the US given the huge size of the US Fed’s stimulus program and government spending. When real rates are negative, investors aren’t getting any return at their cash deposits, so gold becomes competitive with interest bearing assets, and investors flock to it.

The US Fed’s balance sheet has blown out as it implements its unorthodox policy to keep the economy afloat in the face of COVID-19. The central bank has engaged in around US$3 trillion in asset purchases since March 2020²and the US fiscal deficit has soared to around 40% of GDP. That will weigh on the value of the greenback moving ahead, pushing gold over US$2,000. Historically, gold has a negative correlation to the US budget, as can be seen in the chart below.

_{Source: Bloomberg}

The advantage of investing in gold miners rather than gold itself is that their price typically rises more than the gold price itself, as miners’ margins increase from gold production. Many miners pay dividends too. These are powerful reasons to invest in gold miner ETFs when seeking exposure to the performance of the precious metal to offset rising systemic risks caused by unprecedented central bank intervention.

3. Emerging markets

A falling US dollar is often seen as good news for emerging markets, because it makes the cost of US goods and services, which they may import, cheaper in their own currencies. Also, emerging nations often have US dollar debt. If an EM country has a lot of US dollar debt, the weakening dollar deflates the value of that debt in local currency terms and servicing that debt will cost less.

When the US dollar falls, investors also turn to higher-yielding debt from emerging markets and money flows into their bond markets, supporting asset values. This is exactly what we’ve seen during the coronavirus pandemic; emerging market debt has rallied. With interest rates having fallen sharply in developed nations in response to COVID-19, many emerging market bonds remain very attractive for income and growth opportunities.

Within equities, the weaker greenback is also good for countries which export commodities. The weaker US dollar is usually accompanied by stronger commodity prices, such as gold and iron ore, which in turn boosts growth and promotes trade surpluses for commodities exporters such as one of the world’s biggest emerging markets, Brazil.

Both emerging markets bonds and emerging markets equities can benefit from a falling US dollar.

Positioned for currency volatility

These three investment ideas: hedging your international equity exposure; buying gold miners; and investing in emerging markets, are strategies to consider when investing in an environment in which there is pressure on the US dollar. Always speak to a financial adviser to consider your individual financial circumstances, needs and objectives and read the relevant PDS before making a decision to invest. Currency movements are unpredictable and volatile and are just one of the many risks investors have to navigate in these tricky times.