Hedging a Strong Dollar with Inverse ETFs
Strong dollar policies have been a bedrock of our countries finances. It wasn’t long ago when the prevailing wisdom was that all the Federal Reserves quantitative easing, dubbed ‘money printing’ by many was going to make the U.S. dollar worthless through hyperinflation. The opposite has happened so far and we are seeing the U.S. dollar strengthening and staking its claim as the world’s safe haven currency, especially compared with many struggling international currencies including the European Union’s Euro, the Japanese Yen, the Chinese Yuan and the Brazilian Real. So many of these struggling currencies have their own ‘reasons’ for their weaknesses from the collapse in oil prices, to ballooning sovereign debt and trade deficits. Hedging a strong dollar could be a popular strategy over the next few years.
Isn’t a Strong Dollar Good?
In Ronald Reagan times, perhaps. Today, the world is loaded up with debt, more importantly dollar denominated debt. When many international issuers of debt (public or private sector) local currencies are falling in value but their liabilities (U.S. dollar denominated debt) are getting more and more expensive as the debt becomes more burdensome. Add in other variables such as a recession and the ability to repay becomes more challenged.
There is also contagion risk. Since markets are so interconnected globally, debt servicing problems can spread. We’ve seen this in the Eurozone a few years ago and are currently seeing it in Asia. There has been a massive amount of investment in emerging market debt (critics will say from Fed’s easy money policy and risk-chasing) over the last few years.
Of course, a weak or collapsing dollar is not a desirable environment either. A collapse in any fiat currency could lead to a number of nasty outcomes including hyperinflation or debt deflation. Central bank money printing is definitely a headwind that needs to be monitored. We aren’t worried yet and don’t feel the need to buy bitcoin or a bitcoin etf, when issued, for usable currency. Having ample cash on hand is a good enough hedging strategy for now.
The term emerging markets refers to international countries (BRICs-Brazil, Russia, India, China, etc) which are less developed but offer large long-term growth potential. Emerging Market (EM) dollar-denominated corporate debt has lower overall credit ratings than .
The proliferation of ETFs has allowed individual investors who would have never had the opportunity to invest in these obscure asset classes to fully embrace them under the guile of diversification. Emerging market debt issuance spiked in 2014 as risk-hungry investors of all types rushed for the yields these bonds offered:
U.S. large, multi-national companies will feel the weight of a strengthening dollar in a couple ways. The S&P 500 gets almost 40% of its revenues from overseas so we will not be immune to international hardships. Certain sectors will get hit even harder, including technology, energy and materials which get roughly 50% of their profits from overseas. When U.S. companies sell our goods abroad, they get paid in foreign, local currency. If this local currency is depreciating against the U.S. dollar, when U.S. companies bring back the profits and convert them back into U.S. dollars the profits become less in dollar terms. Many companies engage in currency hedging.
Hedging a Strong Dollar
You can reduce some risk of a strengthening U.S. dollar by purchasing U.S. equities that have little or no international exposure. These are typically small cap stocks. Also, health care stocks tend to have less overseas exposure. You can also protect against a strong dollar by using currency hedged ETFs and inverse currency ETFs.
As we’ve seen the U.S. dollar’s strength against so many world currencies, its no surprise we see the price of items priced in dollars, going down. The commodities sector has been hammered over the last couple years or so. To the extent that you believe we’ll see continued strength in the dollar, you may want to hedge commodity exposure with a variety of commodity inverse ETFs, ETNs and commodity pools.
The price of oil can go down for a number of reasons, one of the important ones is a strengthening of the U.S. Dollar (since oil is priced in U.S. Dollars). If you want to hedge exposure to an oil or energy sector position, you may want to consider the United States Short Oil Fund (DNO) which tracks the Light, Sweet crude oil (inverse) and is issued by U.S. Commodity Funds. It seeks to achieve the opposite return (-1X) of the Deutsche Bank Liquid Commodity Index-Oil (West Texas Intermediate, WTI).
One leveraged oil inverse ETN is the ProShare’s UltraShort Oil and Gas (DUG) which aims to deliver two times the inverse (-2X) of the Dow Jones U.S. Oil & Gas Index. According to the S&P Dow Jones Indices’ Fact Sheet, at the end of August, 2015, the Dow Jones U.S. Oil & Gas Index had a frothy combined trailing P/E ratio of 57.81, including negative components, even after oil’s sell-off. There is an ETF that tracks the index is the IYE so you’re basically betting against (-2X) this ETF’s holdings. Interestingly, the top holdings in the IYE (presumably the same as the U.S. Dow Jones U.S. Oil Index) are Exxon Mobil (XOM) and Chevron (CVX) which make up one-third of the fund/index. That kind of concentration is worrisome since every company has risk, no matter how rock solid they may seem.