Is the world finally losing its appetite for the U.S. dollar? Michael Schuman for Time asks the question. There are signs we should be concerned:

• The price of gold has catapulted to new highs and the International Monetary Fund (IMF) is selling 200 metric tons of gold to India’s central bank for $6.7 billion.
• Around the world, U.S. dollars accounted for 37% of new reserves in central banks.

The worst recession since the 1930s may almost be behind us and the beaten-down financial sector seems to be mending. Can the dollar rise from the ashes like a phoenix? Some say perhaps not. In a decade, says one historian, the world won’t be so dollar-denominated. But whether that spells doom is another question altogether.

The U.S. dollar is not going to disappear. But if the talk becomes reality, the greenback could take a hit. Central bankers are the currency market’s buyer of last resort, and thus the private sector’s view of the dollar’s value and stability can be heavily influenced by what they do. (How to play currency baskets).

• PowerShares DB US Dollar Up (NYSEArca: UUP): down 7.5% year-to-date

• PowerShares DB US Dollar Bearish (NYSEArca: UDN): up 8.2% year-to-date

• PowerShares Group 10 Carry Trade (NYSEArca: DBV): up 20.3% year-to-date (How DBV works)

Short-term incentives and measures to stoke the economy are not fixing the real problem of sustained growth as businesses reduce payrolls, bank lending contracts, and consumers save more and spend less, comments Steven Pearlstein for The Washington Post.

The Federal Reserve took bold and necessary steps to prevent the collapse of the financial system. But the Fed also created so much liquidity that some fear that another financial bubble is forming.

As the money flew off the printers, the Fed was cutting interest rates in inter-bank lending to basically zero. However, banks kept interest rates unchanged for everyone else, and the result is that “spreads” between bank-to-bank lending and lending to everyone else are close to record highs.

The entities that are actually borrowing are hedge funds and other investors who use the money to purchase stocks, corporate bonds and commodities, pushing prices higher. Some ETFs to watch for activity include:

• DIAMONDS Trust, Series 1 (NYSEArca: DIA): up 14.0% year-to-date
• PowerShares QQQ (NasdaqGM: QQQQ): up 43.3% year-to-date
• SPDRs S&P 500 (NYSEArca: SPY): up 19.1% year-to-date
• iShares iBoxx $ Invest Grade Corp Bond (NYSEArca: LQD): up 8.9% year-to-date
• iShares S&P GSCI Commodity Indexed Trust (NYSEArca: GSG): up 4.9% year-to-date

The excess liquidity is also being used to finance new “carry trade,” borrowing at low U.S. rates to buy bonds in places with higher rates.

• POWERSHARES DB G10 (NYSEArca: DBV): up 17.7% year-to-date

The Central Bank is determined to stay its course, using anything that will strengthen the balance sheets. Fed officials won’t be increasing interest rates and reducing liquidity until they decide the economic recovery has a proper foothold.

For full disclosure, Tom Lydon’s clients own shares of LQD and QQQQ.

Max Chen contributed to this article.

Currency ETFs are an easy way for the average investor to gain exposure to world currencies, according to Forex Articles.

Experts note that currency ETFs require an understanding of their risks, how they work and the differences between them, as not all currency ETFs are created alike. An investor may offset individual currency risks by investing in a basket of various currencies, such as in one of these funds:

• Barclays Global Emerging Market Strategy [GEMS] Asia 8 Index ETN (NYSEArca: AYT)
• Barclay’s iPath Optimized Currency Carry Exchange Traded Note (NYSEArca: ICI)
• PowerShares DB G10 Currency Harvest Fund (NYSEArca: DBV)
• WisdomTree Dreyfus Emerging Currency Fund (NYSEArca: CEW)

Economic outlook of the country plays a large role in the strength of a country’s currency and corresponding ETF. A trader needs to consider the outlook, which can be affected by price of oil, trade balance inflation rate, political leadership, war, economic status and many more.

For more information on world currencies, visit our currency category. Or take a look at our ETF currency guide to see what other currency ETFs are available.

Max Chen contributed to this article.

For the first time in 16 years, the U.S. dollar is cheaper to borrow than the Japanese yen. This is bad news for the U.S. dollar, as it has  long benefited from positive yield premiums. David Roman for The Wall Street Journal reports that the prospect of the Federal Reserve keeping U.S. overnight interest rates essentially at zero until at least late next year has wiped out the dollar’s premium.

The dollar’s cheapness has sent one positive signal, though: fear in the credit markets has eased a great deal. The Libor (London interbank offered rate) has declined sharply.

On the other hand, this means that investors are less likely to put their capital into dollar assets. It’s more bad news for the dollar, because it’s already being weakened by the massive amounts of money the government has been printing.

• PowerShares DB U.S. Dollar Index Bearish (UDN): up 4.3% year-to-date

• PowerShares DB G10 Currency Harvest (DBV): up 14.6% year-to-date

For more stories about the U.S. dollar, visit our currency category.

The Forex Market

The foreign exchange market, also known as the forex market, is the largest market in the world. In 2007, for example, it garnered $3.2 trillion worth of transactions each day. It’s the quiet giant of finance and dwarfs all other capital markets worldwide.

Unlike most other trading, such as futures, stocks or options, forex trading doesn’t happen on an exchange. It’s not controlled by any governing body, has no central exchange and there are no clearing houses involved guaranteeing trades. It’s a global network, made up of banks, corporations and individuals. The forex is also the most liquid market – there are always ready and willing buyers and sellers for the currency someone is seeking to trade.

The vast majority of currency trading is done bank-to-bank, and when each party enters into an agreement, they both take on the counterparty risk of the other. They’re not only competitors, but they’ve got to cooperate, as well.

There’s no actual buying and selling in the currency market – only trading, hence the need for cooperation.

Exchange traded funds (ETFs) have made entering this market much easier than it used to be. Prior to the launch of currency-related ETFs in 2005, the forex was a challenging market for individual investors to gain access to. Many investors might find this simplified access appealing, especially when you’re talking about a market that’s open 24 hours a day. If you’ve been eager to play this market, there are a rapidly growing number of opportunities to play the currency markets in the form of both ETFs and exchange traded notes (ETNs), which we’ll detail later.

Currency Basics

When entering the currency market, much of the focus is on the eight major currencies, which give you the best over- or under-valued opportunities. The eight major countries that make up the currency trading market are the United States, the Eurozone (Germany, France, Italy and Spain), Japan, United Kingdom, Switzerland, Australia, Canada and New Zealand.

There are many, many more currencies beyond the eight majors, such as the Brazilian real, Polish zloty and Hungarian forint.

Some of the key points to consider when you’re investing in currencies are:

• When trading currencies, yield drives return. Every currency has a yield.
• The forex allows huge leverage; often as high as 100:1 – which means that you can control $10,000 worth of assets with as little as $100 of capital. Remember, leverage works both ways, though.
• Since currency values never stay the same, the carry trade became a popular theory. Carry traders hope to earn not only the interest rate differential between the two currencies, but also look for their positions to appreciate in value. We’ll discuss this in more detail in the next section.
  
• Interest rates matter – a lot. Becoming familiar with the economics of the country in which the currency you are trading holds will help you understand when inflation is looming and when opportunity is knocking.

In currency markets, there’s always a bull somewhere. Why? The foreign exchange market is all about opposites and all about relativity. As one currency gains value, another has to be losing.

Dan McCabe, CEO at Next Investments, points out that one of the biggest advantages to investing in currencies is that it’s a great way to get non-U.S. dollar exposure.

“As an investor, I have nearly all my stuff in U.S. dollars. When I want to buy something, it’s often foreign-made. If I don’t have a hedge for the fact that the U.S. dollar may depreciate, I’m just losing my buying power on the world stage.”

For example, have a look at this five-year chart of the euro vs. the U.S. dollar. For the last three years, the euro steadily gained before falling off mid-way through 2008:

This means that as the euro gained strength, perhaps tourism in Europe suffered as Americans couldn’t afford to go over there and spend as much. But on the flip side, it likely brought tourists over here who were itching to spend and find bargains. Currency is all about relationships, and a currency being either weak or strong doesn’t necessarily mean it’s bad or good.

McCabe sees currencies as more of a buy-and-hold hedge instead of getting caught up in trading. “You’d rather just come in, buy it and put it away and look at it like a foreign money market account,” he says.

The Carry Trade

One of the most popular ways for institutional investors to play currencies is with the carry trade. Putting it simply, the carry trade involves borrowing currencies from countries with low interest rates and investing it in high interest rate countries. The strategy aims to take advantage of the wide spread in interest rates between certain currencies.

As of June 24, some interest rates for various currencies were:

• Australian Dollar, 3%
• New Zealand Dollar, 2.5%
• Euro, 1%
• U.S. Dollar, 0.25%
• Japanese Yen, 0.1%

You can track these interest rates at Daily FX.

With these interest rates in mind, an investor utilizing the carry trade would want to buy Australian dollars with the much lower-yielding Japanese yen, which is one of the most popular carry trade combinations around.

The carry trade isn’t a risk-free strategy, though. One of the biggest risks is if the exchange rate devalues by more than the average annual yield. If you’re using leverage, your losses could be even greater.

ETFs have simplified the carry trade for retail investors. The PowerShares DB G-10 Currency Harvest (DBV) tracks the interest rates of the U.S. dollar, euro, Japanese yen, Canadian dollar, Swiss franc, British pound, Australian dollar, New Zealand dollar, Norwegian krone and the Swedish krona. DBV looks at the three-month interest rates of the G10 currencies and goes long on the three with the highest rates and short on the three with the lowest. The ETF seeks to capitalize on the trend that the currencies with high interest rates generally tend to rise in value relative to currencies that have low interest rates.

Currency Risks

McCabe points out that currencies are non-correlated assets. “The risk you have oftentimes is performance vs. the underlying currency you’re purchasing in.”

As an example, assume that $1 equals 1 yen. If the dollar increases in value, you might get 1 yen for 90 cents – great if you’re traveling to Japan when this happens. However, it’s not so great if you have an asset priced in yen that you bought when dollars and yens were of equal value.

The flip side also works: if the dollar falls against various currencies, you stand to make money on assets based in those currencies if you bought them before the dollar weakened.

When searching for currencies to invest in, McCabe looks at the country behind it. Political upheaval can wreak havoc on a currency.

“I would look for a stable country with strong jurisprudence and rule of law…a country you believe is going to be stable, in case of turmoil.”

Why Use ETFs Instead?

Investing in currencies on your own, without an ETF, can be an arduous task. The currency market is one that never closes. Twenty-four hours a day, trillions and trillions of dollars in trades are taking place. You could find yourself sitting up in the middle of the night, waiting for a key signal to pounce on a trade.

That probably doesn’t sound like the average retail investor’s idea of a good time.

There are now two options for exchange traded currency investing: ETFs and exchange traded notes (ETNs).

Two key differences between currency ETFs and ETNs are:

1. Currency ETNs (like all ETNs) are backed by the full faith and credit of the issuer. If the issuer goes under, you have to get in line with all the other creditors. It’s a small risk, but it’s one to keep in mind.
2. Currency ETNs linked to a single currency are treated like debt for federal tax purposes, according to a 2007 IRS ruling. It means that any interest is taxable to investors, even though the interest is reinvested and not paid out until the ETN is sold or upon maturity of the contract. It also means that investors can’t elect capital gains treatment.

Not all exchange traded currency products are structured in the same way, either.

McCabe points out that it’s wise to be aware of what makes currency products different from one another. For example, Rydex’s CurrencyShares funds are grantor trusts – they hold the actual currency.

The interest earned on them is accrued on a daily basis and reinvested monthly. This reinvested interest is then reflected in the fund’s net asset value (NAV).

On the other hand, PowerShares‘ currency ETFs, PowerShares DB US Dollar Bullish Fund (UUP) and PowerShares DB US Dollar Bearish Fund (UDN), hold futures contracts and are registered as open-ended ETFs. Any gains from futures contracts are subject to 60/40 tax treatment, in which 60% of the gains are long-term, 40% are short-term.

In the bullish fund, the futures contracts are designed to be long on the U.S. dollar against the euro, yen, pound, canadian dollar, Swedish krona and Swiss franc. The bearish fund is designed to be short on the U.S. dollar against those currencies.

WisdomTree’s currency income ETFs invest in either non-U.S. moey market securities, or in a combination of money market instruments designed to provide exposure to non-U.S. money market securities or rates. They are not money market funds. They seek to give investors current income reflective of foreign money market rates available to U.S. investors, as well as exposure to changes in the value of a specific currency relative to the U.S. dollar.

Market Vectors‘ currency ETNs are senior, unsecured debt securities that give exposure to the exchange rate between U.S. dollars and foreign currencies. The underlying indexes are also affected by movements in interest rates in the country of the underlying currency and that of the United States’.

Market Vectors and ProShares also have some double long and double short ETNs for investors looking to enhance their exposure. They aim to double the daily performance of a specific currency. Know the risks of short and leveraged funds before you invest, however. They aren’t for everyone.

Barclays’ iPath currency ETNs measure the relative values of two currencies. In the EUR/USD fund, for example, when the euro rises against the U.S. dollar, the fund increases, and vice versa. The provider also has a currency carry ETN, iPath Optimized Currency Carry (ICI), that seeks to capture the returns potentially available from a carry trade. The pool of currencies the index may apply its strategies are known as the “G10″ currencies, which includes the U.S. dollar, euro, Japanese yen, Canadian dollar and Swiss franc.

How to Choose

At this point, there are enough ETNs and ETFs targeting currencies that investors have a whole range of choices when it comes to figuring out how they want to play them. When choosing currency ETFs, consider the differences between the available funds, how they access currencies and their tax treatment. In short, know what you own.

Perhaps one of the easiest ways is via a broad basket of currencies, which help spread out the risk and lessen the blows a volatile stock market can deliver. Some examples:

• Barclays Global Emerging Market Strategy [GEMS] Asia 8 Index ETN (AYT)
• Barclay’s iPath Optimized Currency Carry Exchange Traded Note (ICI)
• PowerShares DB G10 Currency Harvest Fund (DBV)
• WisdomTree Dreyfus Emerging Currency Fund (CEW)

There are a number of single-currency funds available, as well, along with a number of others that are in registration:

• PowerShares DB US Dollar Bullish Fund (UUP)
• PowerShares DB US Dollar Bearish Fund (UDN)
• CurrencyShares Australian Dollar Trust (FXA)
• WisdomTree Dreyfus Brazilian Real Fund ETF (BZF)
• CurrencyShares British Pound Sterling Trust (FXB)
• iPath GBP/USD Exchange Rate ETN (GBB)
• CurrencyShares Canadian Dollar Trust (FXC)
• Market Vectors – Chinese Renminbi/USD ETN (CNY)
• WisdomTree Dreyfus Chinese Yuan Fund ETF (CYB)
• CurrencyShares Euro Trust (FXE)
• iPath EUR/USD Exchange Rate ETN (ERO)
• WisdomTree Dreyfus Euro Fund ETF (EU)
• Market Vectors – Indian Rupee/USD ETN (INR)
• WisdomTree Dreyfus Indian Rupee Fund (ICN)
• CurrencyShares Japanese Yen Trust (FXY)
• iPath JPY/USD Exchange Rate ETN (JYN)
• WisdomTree Dreyfus Japanese Yen Fund ETF (JYF)
  
• CurrencyShares Mexican Peso Trust (FXM)
• CurrencyShares Russian Ruble Trust (XRU)
• CurrencyShares Swedish Krona Trust (FXS)
• CurrencyShares Swiss Franc Trust (FXF)
  

There are also leveraged funds, which enable investors to maximize the movements of a particular currency. The following funds all double exposure by 200%:

• ProShares Ultra Yen ETF (YCL)
• ProShares UltraShort Yen ETF (YCS)
• ProShares Ultra Euro ETF (ULE)
• ProShares UltraShort Euro ETF (EUO)
• Market Vectors Double Long Euro ETN (URR)
• Market Vectors Double Short Euro ETN (DRR)

In registration include CurrencyShares for Hong Kong, Singapore and South Africa, as well as WisdomTree funds for the Czech koruna, Chilean peso, Israeli Shekel, the Russian ruble and many more.

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

For more stories on currencies, visit our currency ETF category. For more special reports, view our special report page.

The U.S. dollar depreciated against each of the 16 most-active currencies since March 5 as investors worried over the nation’s ability to fund the budget deficit, reports Candice Zachariahs for Bloomberg. Investors are turning to cyclical currencies with strong balance sheets, such as the Norwegian Krone and Canadian dollar.

Treasury yields in between the 2- and 10-year notes increased to a record 2.793%, reflecting investors’ demand for higher premiums on longer government loans and the possibility of inflation eating away returns.

Stephen Gallo, head of market Analysis at Schneider Foreign Exchange, thinks the dollar, which depreciated 5% against the euro, will continue to drop in value, according to Moneynews. Currency traders are responding to risk appetite and the current trend is the pullback of the dollar.

Other experts are also bearish on the dollar. During global recessions, deleveraging and investor repatriation usually strengthens the dollar. But as the global economy bottoms out, the dollar will begin to depreciate, experts say.

Here are some ways to hedge the falling value of the dollar, but there are many currency ETFs available, so be sure to look around:

• PowerShares DBG10 Currency Harvest (DBV): up 10.2% year-to0date

• CurrencyShares Canadian Dollar Trust (FXC): up 9.4% year-to-date

• PowerShares DB US Dollar Index Bearish (UDN): up 2.5% year-to-date

For more stories on currencies, check out our currency ETF category.

Read the disclaimer, as Tom Lydon is a board member of Rydex Funds.

Max Chen contributed to this article.

Now that the U.S. dollar has reached a low for 2009, you may be wondering how you can take advantage of this.

Many investors, retail and institutional, are turning to the currency market in an attempt to alleviate the downside risk. While currencies typically aren’t used as long-term growth vehicles like stocks are, they can provide many benefits to an overall portfolio. One such benefit is that the currency market moves away from the broad market and, like commodities, is an alternative asset class, explains Investopedia.

A few more reasons investors like currencies:

• Currencies also allow investors to benefit from the declining U.S. dollar. In the global economy, investors, while increasing the value of their assets, can still lose ground long-term with the declining dollar.
• Currency also gives investors yield exposure, with different money market rates found in Australia vs. the EU, for example.
  
• Currency fills a void in a large portfolio, and can help cut the downside risk.
  

The recent addition of the WisdomTree Dreyfus Emerging Currency Fund (CEW) will help investors get exposure to currency and yield in emerging and developing parts of the world. This allows investors to participate in currencies such as the Israeli shekel, Polish zloty, Chilean peso and Indian rupee, to name a few.

A couple of other ETFs on the market:

• PowerShares DB G10 Currency Harvest Fund (DBV)
• WisdomTree Dreyfus Euro (EU)
  

Assets: $283 million

Holdings: This fund tracks the interest rates of the U.S. dollar, euro, Japanese yen, Canadian dollar, Swiss franc, British pound, Australian dollar, New Zealand dollar, Norwegian krone and the Swedish krona. DBV looks at the three-month interest rates of the G10 currencies and goes long on the three with the highest rates and short on the three with the lowest.

Objective

The ETF seeks to capitalize on the trend the currencies with high interest rates generally tend to rise in value relative to currencies that have low interest rates. DBV looks at the three-month interest rates of the G10 currencies and goes long on the three with the highest rates and short on the three with the lowest.

What’s Good

DBV gives investors a way to play the carry trade, which is gathering steam after a hiatus.

After developed economies reduced their interest rates to practically nothing, emerging markets with interest rates that are around 12.9% higher now look rather enticing, report Kim-Mai Cutler and Bo Nielsen for Bloomberg.

The Latest News

Goldman Sachs has begun recommending carry trades, which had been on their biggest losing streak in three decades. Thank stimulus plans and near-zero interest rates. In some emerging markets and commodity-rich nations, interest rates are as much as 12.9%, or even higher. From March 20 to April 10, the carry trade saw its biggest three-week gain since at least 1999.

How do currencies traders make a profit off “carry trades?” Well, traders use funds from countries with lower borrowing costs to invest in places with higher rates, and they would then reap in the differences in interest rates. Last year, this strategy was abandoned after volatility, as a result of the central bank policies of individual countries, led to large currency swings.

Typically, people would use dollar, euro and yen to buy up currencies from Brazil, Hungary, Indonesia, South Africa, New Zealand and Australia.

• PowerShares DB G10 Currency Harvest (DBV): up 5.4% year-to-date

Max Chen contributed to this article.

The yen carry trade consisted of borrowing currencies from low interest rate countries like Japan and investing in higher-interest rate countries like New Zealand and Australia. Gary Gordon for ETF Expert reports that during the credit crisis, the yen strengthened by far as Australian dollars and New Zealand dollars declined rapidly. Borrowers had to quickly repay those borrowed yen loans to avoid further losses, further strengthening the yen in a self-fulfilling prophecy-like fashion.

As of late, the Japanese yen ETF has pulled back sharply and is 7.6% off its high reached last December.

Many wonder if the risk-taking has resumed once again among investors. Those who look ahead may assume that the U.S. dollar may resume a downward trend at a time when neither the United States nor Japan will be in a position to raise interest rates. Meanwhile, Australia, New Zealand, Norway… even the European Monetary Union might be in a better position to do so.

• PowerShares DB G-10 Currency Harvest (DBV): up 4% year-to-date

• CurrencyShares Japanese Yen Trust (FXY): down 4.3% year-to-date

• If you believe the yen will continue to depreciate, there’s the ProShares UltraShort Yen (YCS).

Read the disclosure, as Tom Lydon is a member of the board of Rydex Funds.