For U.S. investors, a rising stock market has probably helped beef up your net worth. But before you pat yourself on the back for a job well done, consider one disturbing fact: In terms of global purchasing power, the value of your portfolio may well have gone down, not up.
Relatively few investors in the U.S. pay much attention to the foreign currency exchange markets, unless they're planning a trip abroad for the summer. But lately, currency movements have played a huge role in the financial markets, and all indications suggest that they'll remain important both in the immediate future and for some time to come.
Dealing with currency crosscurrents
Lately, the dollar has faced pressure relative to nearly every major currency on the planet. Overall, the U.S. dollar index, which includes a basket of several currencies, has reached levels not seen since late 2009. Both the Australian and Canadian dollars are now worth more than the U.S. currency, with the Aussie at record highs and the loonie at its highest exchange rate in more than three years.
With Canada and Australia both being resource-rich countries, the strength in their currencies makes sense, now that gold and silver prices have broken out to the upside. But the performance of the dollar against the euro and Swiss franc is more disturbing. The Swiss franc has also moved well above parity versus the dollar, hitting all-time highs in the past month. And even the euro has performed well lately, hitting a 14-month high despite all the concerns over sovereign debt among the eurozone's weaker countries. The only currency that has given the dollar a break lately is the Japanese yen, and that respite came largely from coordinated intervention from central banks around the world to keep the yen from strengthening too much after last month's earthquake and tsunami.
The source of currency woes for the U.S. rests largely in the Federal Reserve's interest rate policy. The European Central Bank is expected to raise interest rates today, with Switzerland potentially following suit. In doing so, they'll join countries around the world, including Brazil and most recently China, in tightening monetary policy to combat inflationary pressures. As rates rise, returns for holders of those currencies will increase, making them look more attractive to investors than currencies in countries with low-rate environments.
Meanwhile, the Fed seems bound and determined to keep interest rates low for the foreseeable future. That has unmistakable benefits for borrowers, including the U.S. government. But it also discourages savers from holding onto greenbacks. For instance, interest rates in Australia greatly exceed what you get from comparable U.S. fixed-income investments. Combined with a falling U.S. dollar, investors have lots of incentive to flee to overseas markets and reap the double-benefit of higher rates plus favorable currency fluctuations.
How to protect yourself
If you're like many investors, your financial life may be totally dependent on the U.S. dollar holding its value. Yet although the dollar's recent declines may eventually reverse themselves, the long-term trend for the greenback has been to weaken over time. Given that you're likely to get paid in dollars for the rest of your life, moving some of your investments away from dollar-denominated assets could help hedge your bets if the dollar falls further.
Here are some ways to diversify your currency exposure:
Direct currency exposure. Currency ETFs like CurrencyShares Euro Trust
(NYSE: FXE)or WisdomTree Chinese Yuan Fund (NYSE: CYB)rise when the dollar falls against their respective currencies. In addition, some currency ETFs pay regular dividends that are in line with local interest rates.
International bonds. Increasingly, you can buy foreign currency-denominated bonds in convenient forms. The SPDR DB International Government Inflation Protected Bond
(NYSE: WIP)owns bonds similar to the Treasury's TIPS, which adjust their principal value for inflation. iShares Emerging Markets Bond (NYSE: EMB)and WisdomTree Emerging Market Local Debt (NYSE: ELD)focus on emerging markets, many of which sport higher interest rates.
Foreign stocks. Finally, just owning international stocks can help hedge against the dollar's decline, especially if the companies involved don't do a huge amount of U.S. business. For instance, even when the foreign markets that international ETFs iShares MSCI EAFE
(NYSE: EFA)and Vanguard MSCI Emerging Market (NYSE: VWO)cover are flat in local currency terms, the ETFs themselves will rise in dollar terms as the dollar falls. That provides protection against a falling dollar.
As long as the Fed is willing to sacrifice the value of the U.S. dollar for the sake of low interest rates, you need to take steps to protect yourself against its decline. Including foreign investments tailored to rise as the dollar falls will help offset the losses of purchasing power that come from the dollar's weakness.
Keep an eye on the international investments that could save your portfolio -- add them to your watchlist today.
Fool contributor Dan Caplinger steps out the way of certain doom. He owns shares of Vanguard MSCI Emerging Markets and iShares MSCI EAFE ETFs. The Fool owns shares of Vanguard MSCI Emerging Markets ETF. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't leave you without protection.