Former President Ronald Reagan once defined inflation as “violent as a mugger, as frightening as a mugger, and as deadly as a hit man.”
Our 40th president wasn’t exaggerating. Inflation is nature’s way of eating your income without you knowing it — at least, not right away.
Although, that’s not the case right now…
According to the U.S. Labor Department, the annual rate of inflation currently stands at 1.0%, while the Consumer Price Index clocks in at 233.46.
But as any Wall Street currency trader will tell you, it’s not what’s happening right now that counts… It’s what’s going to happen — and whether or not you’re positioned correctly for future events.
That’s the case for inflation, which most economists see rising (and significantly so) over the next year or two. According to TradingEconomics.com, the U.S. rate of inflation for 2013 will average out at 2.0% and rise to 3% in 2014 and 2015.
Historically, creeping inflation usually has anxious investors looking for an edge.
Increasingly, savvy investors are turning to a surprising — yet historically effective — inflation-fighting tool: currency exchange traded funds (ETFs).
This is especially true of non-U.S. currency ETFs. With the dollar losing value against other global currencies as the U.S. government takes on more foreign debt, a hedge in a fund that tracks foreign currencies can keep you one step ahead of inflation — and one step closer to your investment goals.
Sound good? At first glance, sure. But it’s important you don’t go into the currency ETF market with blinders on.
Currencies are a unique beast. They’re treated and traded differently than standard equities. What’s more, they have not had a stellar year.
Today, let’s take a look at currency ETFs and see if they have an inflation-fighting role in your portfolio.
What is the currency market?
Currency trading traces its origins in the global forex market, the largest capital market in the world at $4.68 trillion through the end of 2012, according to analysts at the Aite Group.
Highly speculative in nature, forex trading is comprised of global partners — mostly banks, central banks, institutional investors, retail brokers and investors, and large corporations. In a word, these investors buy and sell currencies on an over-the-counter basis. (There is no central exchange for trading currencies.)
Formally known as the foreign exchange market, the forex market enables investors to evaluate currencies based on a country’s economic and political situation, which are normally the most significant drivers of currency rates.
What are currency ETFs?
Currency ETFs allow investors to speculate in the currency market without the risk of investing directly in currencies, and without entering the forex market.
Like all ETFs, currency funds enable investors to invest in a single currency or basket of currencies, while still taking full advantage of fluctuations in the currency market. Most major global currencies (the U.S. dollar, the Canadian dollar, the Chinese Yuan, the British pound, or the Brazilian real) can be invested in via currency ETFs.
Benefits and Drawbacks of Currency ETFs
The majority of U.S investors have their entire portfolios stocked with U.S. companies, and thus are tied directly to the fortunes of the U.S. dollar.
Given the precarious state of the U.S. economy these days, currency ETFs provide U.S. investors some much-needed exposure to non-U.S. currencies.
Currencies are notoriously fast-moving investments. If you’re not prepared to do your homework, or if you’re blindsided by geopolitical events (like the crash of the Japanese economy following the earthquake and tsunami of March 2011), you might think twice before committing any cash to the currency market.
How are currency ETFs traded?
You can buy a currency ETF that focuses on a single country currency, or you can mix and match currencies within a single ETF, hoping the better performing currencies override the poorer performing ones.
There are seemingly as many currency ETFs as Baskin-Robbins has flavors of ice cream. So to keep things simple, consider a conventional play: the PowerShares DB U.S. Dollar Index Bullish (NYSE: UUP), which tracks the performance of the U.S. dollar against key global currencies, like the yen and the pound.
If the dollar rises, the fund goes up; when the dollar declines, the fund’s value declines.
To make a contrarian play, the PowerShares DB US Dollar Index Bearish (NYSE: UDN) works the opposite way: When the dollar declines, the fund fares better.
To leverage the increasingly powerful Chinese economy (the largest buyer of U.S. debt going into 2014), kick some tires with the Wisdom Tree Chinese Yuan Fund (NYSE: CYB).
Note: Global currency ETFs are, in general, having an off year — with share prices down mostly across the board (with the exception of the Chinese currency ETFs, which are up moderately through the first 10 months of 2013).
However, as global bourses strengthen after a soft 2013, especially along the Pacific Rim (including Japan, China and Singapore), currency ETFs are certainly worth a closer look for 2014, particularly as entry price points are low in late 2013.
Trading Strategies
Another school of thought on currency ETFs is to treat them as short-term investment vehicles.
If you can identify a key economic barometer, like lower energy prices in a given region over the course of the next month or two, then you can hone in on a currency fund comprised of that county’s currency, make a quick killing, and then get out and pop the proceeds into a more conventional investment, like a commodity-based ETF.
If you’re bent on becoming a regular currency ETF investor, take that advice and rinse and repeat.
Always do your due diligence first. And be sure to focus your research on interest rates in a given country, as they’re usually the number one factor that impacts currencies — good and bad — in the currency marketplace.
The takeaway? The currency ETF market is the poster child for the phrase “There’s always a bull market somewhere.”
If you dig in, do your homework, study global interest rate patterns, and invest opportunistically… currency ETFs might just be the investment for you.
If not, there’s always a large-cap fund out there with your name on it.
Until next time,
Brian O’Connell for Wealth Daily
Note: In addition to his contributions to Wealth Daily, Brian O’Connell has also appeared as an expert financial commentator on CNN, NPR, Fox News, CNBC, C-Span, and CBS Radio.
