For decades, if not longer, the U.S. dollar has been known as the world's reserve currency. Foreign investors and central banks have gobbled up greenbacks and debt issued by the U.S. government on the premise that the dollar is the world's dominant currency and American economic strength will bolster returns on dollar-denominated investments.
While the conventional wisdom regarding the strength of the dollar has proved to be true over the years, it is important that investors remember that currencies act just like stocks or other financial instruments. They enjoy runs of success and suffer through periods of doldrums. And while the dollar has been a highly desired currency for the international investing community, it experiences periods of decline.
A fall in the dollar isn't cause for panic, though. Savvy investors can exploit the mighty greenback's decline when it happens and profit from it. Best of all, the avenues to profit from a dollar drop continues to increase.
Where to Turn When the Dollar Tumbles
There are generally a few key warning signs that indicate a decline in the dollar is on the horizon. A consistent pattern of key interest rate cuts by the Federal Reserve, a surge in the national debt and rising commodity prices, especially among gold and oil, can all help investors identify potential perils for the dollar.
And when the dollar falls, that likely means other key currencies are rising, because investors are flocking to perceived quality. For example, a tumble in the dollar combined with rising exports and economic growth in Japan would lead investors to the Japanese yen. On the other hand, if U.S. economic growth is stagnant, but Europe and the U.K. are performing well, the euro and British pound become safe havens for currency investors.
Another avenue to consider is the Swiss franc. While Switzerland is in Europe, the country doesn't participate in the common currency and likely never will. In addition, the Swiss government and central bank take almost painstaking efforts to keep the franc strong relative to competing currencies. As of April 2011, the franc ranked as the world's fifth most traded currency with the U.S. dollar behind the euro, yen, British pound and Australian dollar.
Watching the Dollar? Watch Commodities, Too
Because many commodities are denominated in dollars, meaning their quoted price is in dollars, investors should watch certain commodity markets to get a sense of where the dollar is headed. For example, rising oil prices have generally resulted in dollar weakness because the dollar's purchasing power suffers, and consumers get less gas for their cars and heating oil for their homes when crude oil prices rise.
To hedge against the dollar's fall when commodities are in a bull market, look toward commodity-based currencies such as the Australian and Canadian dollars. When precious metals, such as gold, are in high demand, the Australian dollar often benefits. Likewise, Canada's dollar rises when demand for crude oil surges. Another more recent play on a commodity currency is the Brazilian real. In 2011 Brazil stood as the seventh largest economy in the world and is rich with natural resources, particularly oil.
Plenty of Options to Profit from the Dollar Decline
Trading in the foreign currency markets can be daunting as the daily dollar volume in these markets dwarfs that of U.S. equity markets. Investors need to be aware that playing in forex (FX) markets is not for the faint of heart and they can lose more than their initial investment. For many, the best choice is to leave this arena to the professionals and seek out other methods for profiting from a fall in the dollar.
Fortunately, there is no shortage of products to help investors do this. One is the U.S. Dollar Index, which tracks the dollar against a basket of foreign currencies. It is updated 24 hours a day, seven days a week and trades on the New York Board of Trade. There is also a plethora of mutual funds that track foreign bonds or short the dollar against the other currencies. These funds give investors the international exposure their portfolios need without the headache of directly tracking wild intraday swings in the currency markets.
Equities, both international and domestic, provide another area for investors to profit from a dollar slide. If the forecast appears grim for U.S. equity markets, certain foreign markets may be poised to benefit. Of course, there are U.S. stocks that can benefit from a fall in the dollar, too. Large multinational firms that count on overseas markets for a fair amount of their profits benefit when the dollar is weak as they convert a British pound or Japanese yen back into a greater amount of U.S. dollars. Names like Procter & Gamble, General Electric and PepsiCo come to mind.
The Bottom Line
Investors need not suffer at the hands of a weak dollar. The methods to protect one's dollar-based investments are plenty, and effective hedging can serve as more than just protection: it can boost a portfolio's bottom line. In addition, the global economy means there are global opportunities to help investors sleep a little easier when the dollar drops.