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U.S. Dollar Index at Two-Decade High: ETFs to Benefit/Lose

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Thanks to a hawkish Fed, the greenback has been steady this year, with 9.4% year-to-date, 4.9% monthly and 15% yearly gains in Invesco DB US Dollar Index Bullish Fund (UUP - Free Report) . The reason for this rally is red-hot inflation and the resultant hawkish stance taken by the Fed.

April’s U.S. inflation print strengthened expectations that the Fed will continue its aggressive rate hike spree. The Fed hiked the rate in March by 25 bps and in May by 50- bps (which is a highest magnitude in two decades). Markets are pricing in another 190-basis-point rate hike in 2022.

The U.S. dollar index rose to fresh two-decade highs as concerns that tighter monetary policies to tame surging inflation will slow global economic growth, which in turn has weighed on risk sentiment and driven investors toward the safe-haven currency greenback.

It appears to be a win-win situation for the greenback as the global health crisis as well as the economic slowdown have not dissipated yet. This fact provides support to the safe-haven trades. On the other hand, continued vaccination might reverse the pandemic-induced economic slowdown in the United States and bring the economy back onto a faster growth path, which will boost the country’s currency.

Given the above-mentioned facts, the bullish trend in the greenback is likely to continue, at least in the near term.

ETFs to Buy

So, investors looking to play the strengthening U.S. dollar could consider the below-mentioned ETFs:

U.S. Dollar

The dollar strength can sure be played with UUP and WisdomTree Bloomberg U.S. Dollar Bullish Fund (USDU - Free Report) .

Small Caps

Since small caps are closely tied to the U.S. economy and do not get affected by a rising dollar due to their limited foreign exposure, iShares Russell 2000 ETF (IWM - Free Report) could be a good pick. Most large-cap U.S. companies are flocking to protect their profits by currency hedging due to a relentless rally in the dollar.

Hedging activity by Monex's clients rose 22% in March 2022 from March 2021, and was up 24% for the first quarter compared with last year, per vice president of dealing and trading at Monex USA, as quoted on a Reuters article. Thus, small-cap investing is more prudent at this time.

Dollar-Denominated Bond ETFs

Investors seeking EM exposure amid a strong dollar can consider dollar-denominated EM bond ETFs. These funds invest in sovereign debt from a variety of emerging nations via U.S. dollar-denominated securities. Notably, the debt route is less risky than equities. Moreover, most emerging markets have low debt levels compared to the developed countries.

Invesco BulletShares 2024 USD Emerging Markets Debt ETF (BSDE - Free Report) is one such ETF. The fund yields 3% annually and is off only 3.8% this year. The decline in returns is pretty low compared to several other investment alternatives.

ETFs to Lose

Inverse Dollar Fund

Needless to say, if the dollar is rising, a short position on the currency would result in negative returns. Invesco DB US Dollar Index Bearish Fund (UDN - Free Report) should thus be avoided.

Commodities: Gold

The upsurge in the dollar is bad for raw materials and commodities as these are priced in the U.S. dollar. Furthermore, prolonged strength in the U.S. dollar might constrict the growth picture, which in turn would weigh on commodities’ prices. SPDR Gold Shares (GLD - Free Report) lost 1.5% on May 12 due to a sudden dollar strength. Having said this, we would like to note that commodities have been strong this year thanks to the war in East Europe and high inflation.

Large Caps

Since large-cap stocks have greater foreign exposure, the strengthening dollar is negative for this capitalization. BofA Global Research once estimated that every 10% drop in the U.S. dollar translates into about a 3% boost to S&P earnings, as quoted on Reuters. It is expected that the opposite will happen if the greenback surges.

Companies pointing to currency headwinds in their latest earnings reports include Coca-Cola Co, Procter & Gamble and Philip Morris International Inc. Analysts have cut their overall forecast for S&P 500 second-quarter profit growth to 5.6% from 6.8% at the start of April owing to the current headwinds, per a Reuters article. SPDR S&P 500 ETF Trust (SPY - Free Report) should thus be closely watched.

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