An ETF Strategy For A Declining Dollar

Among the most popular calls on Wall Street heading into 2019 was the call for a weaker dollar.

Last year, the Invesco DB US Dollar Bullish ETF UUP gained 7.1 percent, easily making it one of the year's best-performing currency exchange traded funds.

It will take some time for an official dollar bear market to arrive, if it arrives at all, but UUP is off modestly to start 2019. Ongoing dollar weakness could spark renewed interest in a variety of assets, including emerging markets bonds.

What Happened

Neither dollar-denominated nor local currency emerging markets were spared the dollar's wrath last year.

The VanEck Vectors J.P. Morgan EM Local Currency Bond ETF EMLC slid 7.6 percent last year, while a widely followed gauge of dollar-denominated emerging markets debt dipped 5.5 percent.

A weaker dollar could spark a rebound for EMLC this year, a scenario that is materializing on a modest basis — as highlighted by the ETF's 2.73-percent year-to-date gain.

“In an environment with less external pressure, we believe many emerging markets currencies could rally,” VanEck in a Thursday note. “First, a slowdown and perhaps end of the Federal Reserve’s rate hiking cycle seems likely in the coming year.”

Why It's Important

Speculating that emerging markets currencies are poised to rebound this year is one thing. Identifying the winners is another thing altogether. Nearly 20 currencies are represented in EMLC at weights ranging from 2.97 percent to 10.33 percent.

To start 2019, EMLC has been bolstered by the Brazilian real and the Indonesian rupiah, two of the best-performing emerging markets currencies to start 2019, and EMLC's second- and third-largest currency exposures, respectively.

“Second, a fair amount of risk premium is built into emerging markets local rates and EMFX, which looks excessive, in our view, compared to fundamentals such as the growth differential with the U.S., creating a fertile ground for emerging markets rallies,” according to VanEck. 

What's Next

As is the case with other emerging markets investments, there is some risk involved with EMLC. For instance, just under 53 percent of the fund's 277 holdings carry investment-grade ratings and most of those are at the lower end of the investment-grade spectrum. Compensation for that risk is strong, however, as EMLC sports a 30-day SEC yield of 6.8 percent.

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