Using the US dollar as a trading tool

Many investors view cash as part of the defensive, and somewhat static portion of their portfolios, but in uncertain markets it might also be used as a trading tool to act on shorter term views and expectations of currency exchange rates.

The US dollar is one such option that investors could consider, whether through foreign exchange trades or using an ETF like the ETFS Enhanced USD Cash ETF (ASX code: ZUSD).

Using USD as a defensive position

Cash typically forms part of a defensive allocation in a portfolio for liquidity and downside protection, with Australian investors typically using the Australian dollar.

Much like equities and fixed income, diversifying cash can assist with risk management, particularly in volatile periods. For example, holding currencies other than the Australian dollar might buffer the cash allocation in periods where the Australian dollar is weak.

The US dollar often holds appeal to Australian investors as a result of its strength compared to the Australian dollar.

AUD/USD 14 May 2015-12 May 2020

Source: XE.com

The US dollar has traditionally been viewed as a safe-haven asset, with most global central banks keeping it as a reserve currency and many international transactions conducted in the US dollar. The value of the US dollar tends to be less volatile, particularly compared to emerging markets, backed by what is to the most part seen as political and economic stability.

Trade your conviction

Investors can also use cash investments to make tactical decisions on how they expect a currency to perform. For example, investors who believe the US dollar is likely to appreciate, may increase their cash allocation to the US dollar while those who believe it is likely to depreciate may choose to reduce their allocation.

An ETF like ZUSD is a simple and liquid way to trade your convictions on the US dollar, allowing you to move quickly based on your changing market views. It may also be more cost-effective and accessible for some investors when compared to setting up cash deposits internationally or using a currency exchange.

Demand for the US dollar globally driven

The US dollar is heavily used across the globe.

- There is more than $13 trillion in US dollar denominated assets held in banks outside the US, reflecting approximately 15% of world GDP.

- Approximately 80% of global trade financed by the Bank for International Settlements (BIS) is in US dollars (BIS finances 35% of global trade).

The US dollar has also been used by the US Federal Reserve (the Fed) to improve liquidity within the US and other countries by way of swap accords. An example of how this works is as follows: the Fed has an agreement with the Reserve Bank of Australia to exchange US$60 billion of US dollars for Australian dollars and reverses this transaction at a later point in time.

The Fed has permanent swap arrangements with the United Kingdom, Canada, Japan, European Central Bank and Switzerland but set up temporary relationships at the start of the COVID-19 pandemic with Australia, Brazil, Denmark, Mexico, New Zealand, Norway, Singapore, South Korea and Sweden. This has been to support the large demand and tight supply of the US dollar outside the US and has resulted in an increase from US$60million in the first half of March 2020 in swap activity to nearly US$400 billion at the start of April 2020.

Depending on how the COVID-19 pandemic continues to evolve, demand for the US dollar – either through swap activity or broader global activity – may put upward pressure on the greenback. Those who believe this is likely may choose to ‘go long’ on the US dollar by taking exposure to it either by buying US dollars or other means, such as ZUSD.

Currency exchange and equity markets

The exchange rate between the US and Australian dollars correlates negatively with US equity markets as represented by the S&P 500, meaning that the US dollar tends to appreciate against the Australian dollar when the US share market is falling and vice-versa. In other words, the Aussie dollar tends to perform well when markets are rising, which is linked to demand for Australia’s resources-heavy exports. This is demonstrated further in the following charts.

As shown in the correlation panel at the bottom of the chart below, across 5 years there is a negative relationship between the movements of the S&P 500 compared to the USD/AUD rate. In periods of more pronounced downturns, the correlation has become more negative, as seen in the global financial crisis and the more recent volatility in March 2020.

Source: Bloomberg, 14 May 2020

To highlight how pronounced that relationship can be the chart below shows a strong negative relationship between the S&P 500 and the USD/AUD rate in the recent months of COVID-19 driven volatility.

Source: Bloomberg, 14 May 2020

An enhanced approach to the US dollar

Exposure to the US dollar  may assist as a buffer against weakness in the Australian dollar and offer diversification in the cash allocation of a portfolio. Alternatively, investors may choose to consider US currency as a trading tool for a short-term tilt to access any strength they may anticipate in the US dollar.

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