The Dollar Drag

By Penelope Wang

Have you hedged your portfolio against the falling dollar? If not, there's still time to act. Since January 2002 the greenback has declined 25% against the euro and 16% against the Japanese yen. And many foreign-exchange experts say the dollar may drop an additional 5% to 10% against major currencies over the next year. One key reason for the dollar's woes is the bulging U.S. trade deficit, which is likely to top $600 billion, or 6% of GDP, in 2004.

Lower U.S. interest rates have also led fixed-income investors to seek out countries offering higher rates. And the swelling budget deficit, which threatens to slow U.S. economic growth, has cast doubt on the greenback's outlook just as many overseas economies are starting to rebound. Says Marc Chandler, chief currency strategist at HSBC USA bank: "The dollar is in a long-term decline."

The weakening greenback hurts returns by dragging down the value of dollar-denominated assets, notably U.S. stocks and bonds. Foreign investors keep their money at home, which softens demand here. To gauge the impact of a further dollar decline on investments, RiskMetrics Group, a New York City quantitative-research firm, ran a so-called economic-stress test, which analyzes statistical correlations between currency moves and the markets. If the euro and the yen each rise an additional 10% against the dollar from levels in early November, the study found, the Lehman Aggregate Bond Index could slip 0.6%, which means that a $10,000 bond would lose about $60. It would cost the S&P 500 index 3.4%, the NASDAQ 4.5% and the Dow 3.2%. On opposite shores, RiskMetrics found that the weaker dollar could cause the FTSE 100 to edge up 0.43%, while the Nikkei might zoom 12.97%. Says RiskMetrics strategist Mike Thompson: "The findings reaffirm the importance of owning both U.S. and foreign investments."

The most direct way to hedge against the falling dollar is to invest in foreign currencies. But active foreign-exchange trading is a high-wire act. Instead, consider buying CDs that are denominated in major foreign currencies. They're available online at Everbank. One popular option, according to Everbank president Chuck Butler, is the commodity-indexed CD, which tracks the currencies of four major exporting nations: Australia, New Zealand, Canada and South Africa. Current interest rate: 4.25%. If the dollar moves up, though, you can lose money in these accounts. So consider this strategy for only a small portion of your portfolio.

Emerging-market bonds are another way to capitalize on the dollar's plunge. In addition to the currency kick, many developing-country issues offer higher yields than U.S. Treasuries. Emerging-market bond funds have already had a mighty run, gaining 32.5% over the past 12 months. But Leila Heckman, head of Heckman Global Advisers, believes these markets have further to grow. For most individuals, the best way to invest is through an emerging-markets bond fund. A top choice is PIMCO Emerging Markets Bond, which has ranked in the upper 20% of its peer group. Its current yield: 5.09%.

For the strongest long-term returns, however, focus on international stock funds. By owning equities, you are positioned for bigger gains than you are in a CD or bond fund. With many countries showing signs of economic recovery, small foreign stocks are outperforming their larger peers, a trend that is likely to last another year or so, according to investment pros. Consider a fund like Vanguard International Explorer, which holds small and midsize foreign stocks, or Julius Baer International Equity, a fund that buys stocks of all sizes.

One last tip: even if the dollar rebounds, continue to keep a stake in foreign investments. By staying fully diversified, you are minimizing the risk to your portfolio wherever the dollar is headed next.

Penelope Wang is a senior writer for MONEY magazine