Dollar ETFs Really Need Interest Rates To Rise This Year

The PowerShares DB US Dollar Index Bullish UUP, the U.S. Dollar Index tracking exchange traded funds, and the actively managed WisdomTree Bloomberg U.S. Dollar Bullish Fund USDU are up 3.2 percent and 4.7 percent, respectively, year-to-date.

Those gains have been fueled in large part by market participants baking into the dollar an interest rate hike by the Federal Reserve, something the central bank eschewed at the conclusion of its September meeting Thursday.

Post-Meeting Reactions

The immediate reaction was forgettable for the greenback and ETFs such as UUP and USDU. However, on Friday the dollar ETFs are trading higher, led by a gain of half a percent at this writing for UUP.

What that says is that the door is still open to a rate hike sometime this year, either at the Fed's October or December meetings. More good news for UUP and USDU: Expectations for a 2015 rate hike were not significantly damaged by the Fed's decision Thursday to pass on such action this month.

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“The fact is that the interest rate market’s implied probability for a rate hike in 2015 did not shift greatly. What has occurred was the removal of the embedded risk premium for a hike at yesterday’s Fed meeting, and a small reduction from the October meeting due to a number of professionals expecting the Fed to make some sort of pre-commitment to a hike at that meeting,” said Rareview Macro founder Neil Azous in a note out Friday.

What Expectations Remain?

With 2015 rate hike expectations barely lower Friday than they were Thursday, perhaps that is a sign investors were too hasty in departing the greenback. For example, UUP has bled almost $362 million in assets over the past 90 days, according to issuer data. Only one PowerShares ETF has lost more money over that period.

Since the start of the current quarter, USDU has lost a more modest $16.2 million. Still, that number is confounding when considering all the negative headlines regarding emerging markets currencies investors have been treated. USDU, by way of being actively managed, can short emerging currencies. For example, over 11 percent of the ETF's weight is short the sagging Mexican peso and Brazilian real.

Near-Term Catalysts

In the simplest of terms, the most important near-term upside catalyst for UUP and USDU is market participants reconfiguring expectations that a rate hike is going to happen this year.

“As a result, the decline in the US dollar is mostly a function of the decision not to hike at the September meeting, and a marginal decline in the probability of a move at the October meeting. The key risk in the near-term remaining for US dollar longs is that the market removes the implied probability – or risk premium –of an interest rate hike in 2015.

"At this point there has not been a major shift to that view as the unconditional probability of a move in December was effectively unchanged after yesterday’s meeting,” added Azous.