Most U.S. investors don't think much about currency exposure. But foreign exchange plays a major role in global commerce, and as shareholders in multinationals based in the U.S. can attest, fluctuations in the value of the U.S. dollar can have a huge impact on stock prices.
To help people hedge foreign exchange risk, currency ETFs offer investors direct exposure to changes in currency values. 2017 was a generally weak year for the U.S. dollar, and the performance of some key currency ETFs shows the crosscurrents around the world for the greenback.
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Currency ETFs in 2017
How these currency ETFs gave investors foreign exchange exposure
The way currency ETFs generally work is fairly simple. The underlying fund opens positions in the underlying foreign currency, either through direct short-term investments or by using futures contracts. The value of the positions moves up or down in line with the appreciation or depreciation of the specified foreign currency, less any expenses that the fund bears. For the CurrencyShares funds above, one share of a currency ETF is equivalent to a fixed amount of currency, although that amount has fallen over time because of the need for the funds to pay expenses from their own resources. Low interest rates have meant that the income that these funds produce internally is insufficient to cover expenses in some cases.
Why the dollar sank in 2017
A look at returns for these ETFs shows the prevailing trends across the global economy. The euro surged in 2017, largely due to stronger economic growth for the eurozone than most analysts had anticipated coming into the year. Brexit-related concerns that elections in key countries like France and Germany would potentially bring in anti-euro leaders proved unwarranted, and geopolitical pressures combined with less accommodative interest rate policy in the U.S. has made the European currency more attractive by comparison.
Many of the same factors helped lift the British pound as well. Manufacturing activity in the U.K. has been relatively strong, and the fact that the Brexit decision hasn't led to widespread economic disruptions as initially feared has lent greater stability to the market.
Meanwhile, recoveries in commodity prices have helped strengthen economies that rely heavily on natural resources. Currency prices in Brazil, Australia, and Canada had all suffered when prices of oil and various precious and industrial metals had fallen in past years, but the recovery in crude and the boom in many base metals have helped lead to a recovery for the three currencies.
On the Pacific Rim, initial projections had expected dollar weakening against currencies in Japan and China as well, but the damage was not nearly as substantial as some had feared. Gains in economic strength haven't been as substantial in Asia as they have been in Europe, and so cross-currency trading between the euro and the major Asian currencies has helped keep exchange rate gains in U.S. dollar terms somewhat in check. The same impact helped hold the Swiss franc down, with efforts to prevent its appreciation against the euro in past years finally leading to a shift back down toward the relative levels that had prevailed before 2015.
Keep your eyes on currency in 2018
Relatively few investors buy shares of currency ETFs, and the risks involved aren't so strong as to make hedging investments required for ordinary investors. Knowing what's happening in foreign exchange markets is nevertheless helpful to understand the impacts on many key players in the global economy.
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