Emerging market companies have borrowed cash denominated in the U.S. dollar, but a strong USD would make it harder for these companies to repay debt obligations, raising default risks overseas and the potential for capital flight, which would further support dollar exchange traded funds.
The PowerShares DB U.S. Dollar Index Bullish Fund (NYSEArca: UUP), the largest dollar-related ETF, has strengthened 10.2% year-to-date. UUP tracks the U.S. dollar against a basket of currencies, including the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. [Global Currency War Leaves U.S. Dollar ETFs On Top]
The Bank for International Settlements warned that emerging market firms have taken on greater dollar-denominated debt over recent years and that repayment will become increasingly difficult due to the strengthening USD or weaker local currencies, reports Alen Mattich for the Wall Street Journal.
If more of these firms come under stress, the governments may have to bail the companies out. Consequently, the perceived weakness in the economies could instigate capital flight – a large-scale withdrawal of financial assets, potentially fueling a cycle that would put more upward pressure on the greenback.
Currency traders who believe the greenback could capitalize on the potential problems in the emerging markets can also take a look at the actively managed WisdomTree Bloomberg U.S. Dollar Bullish Fund (NYSEArca: USDU). USDU has been gaining investment interest and is up 8.3% year-to-date. The ETF tracks a broader basket of developed and emerging market currencies, including the euro, yen, Canadian dollar, Mexican peso, pound sterling, Australian dollar, Swiss franc, South Korean won, Chinese yuan and Brazilian real.
Specifically, unlike UUP, USDU includes a 17.9% exposure to emerging currencies. Consequently, the WisdomTree offering could outperform if emerging market currencies begin to significantly depreciate against the greenback.