The currencies to bet on now
Professional currency trader Fadi Zaher reveals three ways investors can benefit from a stronger dollar in the medium to long term.
Each week, a professional investor tells MoneyWeek where he'd put his money now. This week:Fadi Zaher, head of bonds and currencies, Kleinwort Benson.
Extremely low volatility in the currency markets has revived investors' appetite for borrowing in currencies with low interest rates (such as the Swiss franc) and investing in ones with higher interest rates (the Australian dollar, for example). This is known as the carry trade'.
In 2007, investors' confidence in the carry trade was also high. But back then, many were caught off guard when the carry trade began to unwind, due to rising risk aversion in the financial markets. Should this happen again, the US dollar is expected to strengthen against most currencies.
Meanwhile, the US central bank, the Federal Reserve, is set to keep reducing its monthly bond purchases in the third quarter of 2014 (subject to the strength of the American recovery). If this continues, the market is likely to start focusing on the potential for rising rates in America. This is another factor in favour of a stronger dollar.
As for the pound, British tourists have been enjoying the prospect of cheaper holidays abroad due to the rising value of sterling this year, owing to markets pricing in a rise in interest rates before the end of 2014. These expectations have pushed sterling above $1.70 to the US dollar.
But now that a rise in rates is largely priced in, the value of sterling against the dollar could be overstretched. So, in the next few months, we expect sterling to stay within a range of $1.65 to $1.75.
In the longer run, we expect the US dollar to strengthen against sterling we see it as currently being undervalued against the pound by about 15%.
The euro has remained resilient due to strong demand for the currency at least up until the European Central Bank (ECB) embarked on its new monetary stimulus programme in early June.
The bank's latest decision to battle low inflation levels in the eurozone pushed the single currency down from around $1.39 to the US dollar, to $1.36, and from £0.81 to the pound, to £0.80.
Although the risks of the eurozone debt crisis seem to have been extinguished, outstanding issues could resurface in the second half of the year, as the panic last week over Portuguese bank Espirito Santo shows.
For one thing, there are doubts that the ECB's latest monetary measures will be sufficient to tackle deflation, and for another, the European banking stress tests in the autumn this year could dent investor confidence.
As a result, we remain cautious about the euro, due to headline risks. Over the next few months the euro could fall to as low as $1.30 versus the US dollar.
Over in Asia the Japanese yen has range traded between 100 and 105 per US dollar and is likely to remain around these levels in the near term as the Bank of Japan (BoJ) continues to boost the amount of yen in circulation in the economy by buying bonds.
The BoJ has increased the amount of yen in circulation by 50% of the size of the Japanese economy since April 2013. That compares to 25% of GDP for the Federal Reserve and 24% for the Bank of England. However, should the BoJ slow down its monetary expansion, the yen could strengthen to 95 per US dollar.
Playing the currency markets can be tricky, but there are at least three investment channels through which investors can benefit from a stronger dollar in the medium to longer term.
First, exchanging a portion of sterling, euro or yen cash into US dollars.
Second, investing in an exchange-traded fund that tracks a currency pair, such as US dollar versus sterling, or a basket of major currencies versus the US dollar.
Third, investing in US dollar assets, such as bonds or equities just remember that this strategy involves taking on asset-specific risks, rather than currency exposure alone.