How To Invest in Foreign Currencies

Investors may wonder how to protect themselves from the risk that the dollar could plummet against other currencies. People wonder how to invest in foreign currencies. The solution may be to invest in U.S. based mutual funds that invest in unhedged foreign currency denominated bonds.

It is important to read the mutual fund prospectus and all other literature published by the fund to see if the assets are hedged or unhedged against a drop in the value of the local currency. If the assets are hedged then you are not getting the investment in a foreign currency; instead you will get the value of the foreign bonds in dollar terms, so if the dollar plummets then you would lose money even though you bought a foreign currency bond fund.

Unhedged Foreign Currency Bond Funds

So the objective is to get an unhedged foreign currency bond fund and then examine the fund’s documents to see what percentage is actually in foreign currency bonds and what percentage is allowed in other investments. Some funds hold 20% or even 50% in dollar denominated assets, which is not what I would call an investment in foreign currency.

In making plans to invest in foreign currency denominated bond funds one must estimate how much would the dollar fall against the currency of other nations. The Fed wants to devalue the dollar to stimulate exports and create inflation so as to motivate people to buy things instead of save money. However, other countries, especially China, want to avoid having the dollar decline in value.

International Competitiveness

All nations face tremendous domestic pressure to devalue competitively against each other to stimulate exports. Only few small countries like Singapore, Switzerland and the Nordic countries seem to be able to resist the impulse to devalue, at least some of the time they do. Also, there is really no comparable alternative to the dollar in terms of a truly deep, liquid market. And the Euro has lost a lot of credibility and has a good probability of suffering from more problems with insolvent government members and bad bank loans, and will eventually break up.

The Dollar’s Track Record

The track record of the dollar since 1973 to now was that its index dropped from 108 to 76, a 30% drop, which is 0.8% a year. Since this is relatively minor compared to a hypothetical nominal total return on equities of 9% over the past century, then relatively speaking, the past performance of the dollar was not that bad. Further, the European Central Bank may merely be posturing on rate increases but ultimately will be forced to cave in and reverse course and engage in rate cutting and money supply expansion in a year if the Irish and southern Europe area’s debt problems get worse, which I think will happen. So I recommend that you do not panic about the dollar. Diversification into other currencies with low expectations of profit is OK. However, do not panic and blindly buy any foreign currency investment.

The Big Threat

There is the threat of storm clouds on the horizon. During the time from the Great Depression when Roosevelt devalued the dollar until now the dollar has been a haven currency that went up whenever trouble occurred in the rest of the world. This pattern has gone on so long that people have gotten used to it and assumed that it won’t change. But there is the risk that a dramatic event that only occurs once a century could occur and that is that this paradigm could shift and the dollar could become like any other currency where it would not benefit from or been seen as a safe haven currency.

Recently the real rate of interest on U.S. Treasury TIPs went up during QE2, yet the dollar did not appreciate. This is abnormal. (Of course QE is abnormal.) When interest rates rise in a country then its currency should rise. This implies the markets anticipate the dollar will weaken. Also during the recent crisis in OPEC countries the dollar did not increase in value.

So perhaps there is a paradigm shift and the dollar is no longer a significant safe haven currency but is merely a place for foreigners to diversify an ever-smaller allocation into. So keep your mind open to the idea that the old paradigm could finally have been broken.

About the author

Don Martin, CFP®

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