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The Come-Back Greenback?

You'd think the U.S. dollar had bitten the dust from all the breathless reporting of its savaging in the foreign exchange market. From the headlines, you'd think the world was selling dollars in 2008 en masse. But it's been worse. Consider that the currency used by the average G-8 plus five nation appreciated by just 2.2 percent against the greenback in the first seven months of 2008. It doesn't sound

You'd think the U.S. dollar had bitten the dust from all the breathless reporting of its savaging in the foreign exchange market. From the headlines, you'd think the world was selling dollars in 2008 en masse. But it's been worse. Consider that the currency used by the average “G-8 plus five” nation appreciated by just 2.2 percent against the greenback in the first seven months of 2008. It doesn't sound like much, but given it's a multi-year uptrend, the continued dollar depreciation hurts all the more. (The “G-8 plus five” includes the developed nations, as well as some developing countries, such as India and China.)

Here is the interesting part: The rate of appreciation slowed as 2008 progressed. The group's average gain against the dollar at their highs this year was 5.9 percent. So, the dollar has been doing some clawing back.

In fact, the rallying dollar has caught the eye of investors and advisors alike, and caused many to wonder if this is an early indication of a secular dollar turnaround. Let's not get ahead of ourselves, though. When considering a dollar rebound, you have to be realistic. Yes, our currency will eventually strengthen. The question plaguing investors and their advisors is what we'll have to weather beforehand.

That's where the central banks come in.

Fed Prescience

Central banks are usually lead footed in their attempts to steer economies. The U.S. Federal Reserve, it must be said, was fleet in its response to the sub-prime mess once the headlines broke. The Bernanke Bunch was first out of the gate with discount rate cuts and open market maneuvers.

Though the mortgage crisis also rippled through European markets, central bankers on the Continent and in Britain were much less responsive. The Fed lowered the borrowing rate at the U.S. discount window 450 basis points, and pushed down the cost of Fed Funds 62 percent while the European Central Bank stood pat. The Bank of England dragged its feet before being forced into cutting 50 basis points off its official rate. Higher interest rates abroad enticed capital from the U.S. market into higher-yielding regions, adding to the greenback's woes.

The Fed has been slashing rates to keep recession at bay, while other central banks, led by the ECB, have kept rates high to combat inflation. “The dollar's decline is largely cyclical, having to do with the Federal Reserve stopping rate rises, then cutting rates aggressively before other central banks such as ECB,” says Marc Chandler, chief currency strategist for Brown Brothers Harriman. “We think that the dollar's decline is fundamentally driven by these cyclical factors, and the good news is that the cyclical factors are just about over,” he adds.

In fact, the inflation-fighting stance of the Europeans and the Brits is costing them dearly. Cracks are starting to appear in the economic foundations of the U.K. and euro zone. A further slowdown in global growth through the end of 2008 could cause wholesale craterings, which might force European central bankers to make up for lost time with aggressive rate cuts of their own. The attractiveness of pound sterling and the euro would then wane as their yields fall, allowing the dollar to rally.

Keep in mind that foreign exchange is a game of relative economic performance. Even in challenging economic conditions, the dollar can appreciate against other currencies if our trading partners are faring worse.

The dollar is, in fact, already bottoming against the Canadian loonie and the British pound, according to Brown Brothers' Chandler. “We're at the tail end of the greenback's multiyear decline,” he says. “In the coming months, we see the dollar's base broadening [against other currencies] for an even better recovery going forward.”

Large trade deficits are typically associated with weak currencies, but Chandler believes that the U.S. trade imbalance may be overstated. “Half of our trade deficit can be accounted for by the shipment of goods within the same company,” he says. “When a company like General Motors breaks a system up in Ontario, Canada, and exports it back to GM in Detroit, the government tells me that's a trade deficit. I say that's a movement of goods within the same factory. The movement of goods from one side of that factory to the other is not a trade deficit.”

Prepping For A Dollar Rebound

Portfolios that have been tacking with the short dollar wind will at some point have to come about. Smart investors and advisors should have their moves mapped out in advance for a course correction. There are a number of ways a portfolio can amp up its exposure to the dollar. Adding Treasury securities is a tried-and-true method (there are several mutual funds that specialize in Treasuries), but risks the upset of a carefully crafted asset allocation. Toss in too many of these and you may end up with a more conservative portfolio than you desire. Better to get your exposure through the currency market which isn't well correlated with either equities or debt.

Two mutual funds offer long exposure to the U.S. Dollar Index (USDX), a currency basket comprised of the euro, the Japanese yen, the British pound, the Canadian loonie, the Swiss franc and the Swedish krona. Together, these six currencies represent the bulk of international trade with the United States. The current level of the USDX reflects the average value of the dollar relative to a 1973 base period.

The ProFunds Rising U.S. Dollar Fund (RDPIX) attempts to provide 100 percent of the daily return of the USDX while the Rydex Strengthening Dollar 2x Strategy (RYSDX) uses more leverage to deliver 200 percent of the index's daily return. Both funds use derivatives such as swaps, futures, options, forward contracts, structured products and warrants to achieve their investment objectives.

Adding a mutual fund to a portfolio is simple and easily understood, but requires capital. Either fresh cash must be committed, or existing assets must be liquidated to free up the lucre needed to purchase fund shares. An investor using the Rydex product, of course, requires only half the capital commitment of the ProFunds portfolio. But don't expect twice the compound performance out of RYSDX. The funds are geared to provide multiples of the index daily return. Over longer time periods, return differentials may vary considerably. The compound annual loss for RYSDX over the past three years, for example, was only 1.5 times that of RDPIX even though the Rydex fund's volatility was twice that of the ProFund product.

If cash isn't available for a currency overlay, some short-dollar-appreciated assets may have to be liquidated to finance the portfolio tilt.

Exchange-Traded Funds

Last year, the PowerShares DB U.S. Dollar Index Bullish Fund (AMEX: UUP), an exchange-traded product tracking a portfolio of dollar index futures, was launched to compete against bullish dollar mutual funds. The ETF offers a number of distinct advantages over its open-end rivals. First of all, no dealer agreement need be negotiated which allows it to be used without delay whenever hedging or portfolio tilting is required. The fund is thus fully portable and can be transported to virtually any securities account. Its expense ratio, too, is considerably lower than comparable mutual funds (see table). The fund can also be priced and traded intraday, is marginable and can be used as collateral. On the downside, it's subject to bid/ask spreads and its market price may, at times, vary from net asset value.

The ability to trade the ETF on margin, though, makes it especially useful for hedging purposes. After all, the essence of hedging is leverage: You need to be able to overlay an exposure on existing portfolio assets cheaply. Buying UUP under Reg. T gives an account a double long dollar exposure similar to the RYSDX mutual fund, but at a third of the cost.

Keep in mind that the exposure obtained with a margined UUP position would be similar, not identical, to owning RYSDX. Largely, this is due to tracking error embedded in RYSDX. It seeks to provide 200 percent of USDX's daily — not compound — return. Additionally, an amalgam of derivatives such as swaps, futures and options are employed by Rydex managers. UUP, on the other hand, relies upon fully collateralized dollar index futures as a source of returns. The discount earned from the portfolio's Treasury bill collateral and the methodology used to roll futures positions forward also skews the ETF's return, both positively and negatively. Add the effect of daily compounding, the differential in expense ratios and the drag from interest on the debit balance financing the ETF position, and pretty soon a healthy spread develops.

Take, for example, a five consecutive trading-day stretch in June 2007 when dollar appreciation produced a return rift favoring the margined ETF (see table 2). The differential reversed in the mutual fund's favor later in October when the greenback slumped over another five-day run.

Nobody relishes the prospect of redeploying assets in response to seminal market changes. With leveraged exposure to the dollar now available through mutual fund and ETF formats, though, shifts in the foreign exchange market can be more quickly managed than ever before.

If that's not a picnic in the park, it's at least worth a sandwich or two.


Some funds that let you bet on the direction of the dollar.

Fund Name Ticker Expense Ratio Annual Return Annual Volatility Correl vs. SPX Correl vs. LBAGG
ProFunds Rising
U.S. Dollar Fund
RDPIX 1.49%* -9.4% 7.1% -8.1% -24.2%
Rydex Strengthening
Dollar 2x Strategy
RYSDX 1.66 -16.7 14.5 -7.1 -24.0
PowerShares DB U.S. Dollar
Index Bullish Fun
UUP 0.50 -7.0 9.4 -0.1 -25.0
PowerShares DB U.S. Dollar
Index Bullish Fun (Margined)
UUP 0.50** -20.5 21.3 -1.1 -25.6
Standard & Poor's
500 Index
SPX -10.4 18.6 -1.1
Lehman Bros.
Aggregate Bond Index
N/A 4.4 4.6 -1.1
*ProFund Advisors has waived investment advisory and other fees to limit share expenses to 1.49 percent through November 30, 2008. After that date, the expense limitation may be terminated or revised. Without the limitation, the expense ratio would have been 1.78 percent per annum.
** Does not include margin interest which averaged 6.2 percent per annum over the period.
Source: Brad Zigler
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