CEW: Look To EM Currencies For Dollar Hedged Real Yields – WisdomTree Emerging Currency ETF (NYSEARCA:CEW)

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(Source – Pexels/Burst)

A little over a week ago I discussed the ongoing instability among emerging market currencies in “A Closer Look At Emerging Market Currency Instability“. To summarize, I believe that the bulk of global money creation via QE in the developed world had a little inflationary impact because the conjured money trickled over into EMs. Instead of creating sky-high inflation that many feared would occur at home, it did abroad and has catalyzed the near or complete collapse of a multitude of EM currencies.

Today, these countries are raising rates far above inflation to stop the bleeding and boost their currencies. The problem is that the shortage of U.S. dollars is so extreme that these economies effectively owe more money in local currency the stronger the dollar rises, creating a vicious feedback loop against EM currencies.

That said, the light at the end of the tunnel is coming. I don’t believe the pain for some EM currencies is over, but there are signs of change that are creating a great defensive buying opportunity for some currencies. Chiefly, the reintroduction of QE in the EU and likely the U.S. during a period of rising wages in the developed world (and ultra-low rates).

As the Fed prints money to keep repo markets (and MMT bent politicians) happy, the dollar shortage comes ever sooner to a close. When that occurs, it would probably be best to hold more than just gold and perhaps bitcoin. One ETF that I think will perform particularly strong on a risk-adjusted and systemic exposure weighted basis is the WisdomTree Emerging Currency ETF (CEW).

By in large, nobody has heard about this ETF. For most investors, it seems pretty exotic. However, it has very low exposure to most assets and, unlike gold and bitcoin, offers a positive yielding hedge against the dollar. Now that the U.S. dollar seems to be reaching peak levels, it may be time to begin to look to the ETF for some alpha.

The WisdomTree Emerging Currency Fund

Before we talk macro, let’s talk about this fund specifically. The fund invests in the most liquid and highest yielding emerging market currencies. The holdings are also evenly partitioned between geographic regions and include Chile, Poland, and India, among others.

I have to admit that the fund is currently a bit undercapitalized and has closure risk that investors should be aware of. It currently has only $20M in AUM, and although I expect it to rise as the fund’s 1.8% yield (and rising) becomes increasingly attractive, investors who require liquidity may want to avoid the fund for now.

Take a look at how AUM has moved relative to the price of the fund:

ChartData by YCharts

As you can see, when the fund was first launched during the midst of the great recession, the performance was stellar and the fund has very high inflows. Since around 2011 when inflation expectations plummeted, the fund began to underperform and investors sold their stake. The huge dollar rally of 2015 and the subsequent era of dollar strength has further exacerbated fund flows.

All said, now that yields are at extreme lows and the U.S. dollar at an extreme high, I have a feeling the tide may change for the fund over the coming months. Take a look at its performance compared to the Invesco DB USD Bullish ETF (UUP):

ChartData by YCharts

As you can see, the two are highly negatively correlated and the U.S. dollar is currently at its resistance level. Until Oct. 2nd, I had a significant bullish position in the U.S. dollar and have since trimmed most of my holdings due to increasing QE concerns and falling short-term rates. I still hold a small position in case it has a “blow-off top”. But after this positive trend is over, I expect the U.S. dollar to crash and boost CEW.

What Exactly Does CEW Hold?

Let’s talk a bit more about the actual fundamentals of CEW compared to the U.S. dollar and other developed world currencies. For me, the single most important metric for assessing a currency is its real interest rate or the short-term interest rate (earned by the currency) minus the country’s inflation rate (which usually causes currency devaluation). The higher the metric, the higher the currency.

Beyond that, I care about the current account balance, FX reserves, and government debt to GDP which has significant long-run impacts on currencies. In general, a country with a positive current account balance, high FX reserves, and low government debt to GDP will have a strong currency. Of course, the U.S. has none of those and is perhaps the world’s strongest currency. In my opinion, the U.S. dollar will only be able to avoid its negative fundamentals for so long.

Speaking of which, here is a table of these fundamentals for developed world currencies:

Country GDP QoQ Real Interest Rate Interest rate Inflation rate Gov. Budget/GDP Debt/GDP CA/GDP
United States 2.0% 0.3% 2.0% 1.7% -3.8% 106% -2.40
Japan 0.3% -0.4% -0.1% 0.3% -3.8% 238% 3.50
Euro Area 0.2% -0.9% 0.0% 0.9% -0.5% 85% 2.90
Developed Avg 0.8% -0.3% 0.6% 1.0% -2.7% 143% 1.33

Let’s see what we have here. Essentially zero GDP growth, negative real interest rates, government deficits, extremely high public debt leverage, and low to negative current accounts. In a normal world that did not have central bank managed currency, these currencies would be crashing compared to others.

Here are the others. These are the fifteen EM currencies held in CEW that all have an equal weighting around 4-4.5% of the fund’s holdings:

Country GDP QoQ Real Interest Rate Interest rate Inflation rate Gov. Budget/GDP Debt/GDP CA/GDP
Turkey 1.2% 7.2% 16.5% 9.3% -2.0% 30% -3.50
Thailand 0.6% 1.2% 1.5% 0.3% -2.5% 42% 7.50
Indonesia 4.2% 1.9% 5.3% 3.4% -1.8% 30% -3.00
Philippines 1.4% 3.1% 4.0% 0.9% -3.2% 42% -2.40
Russia 0.2% 3.0% 7.0% 4.0% 2.7% 14% 7.00
Malaysia 1.0% 1.5% 3.0% 1.5% -3.7% 52% 2.30
Mexico 0.0% 4.6% 7.8% 3.2% -2.0% 46% -1.80
India 1.0% 1.9% 5.2% 3.2% -3.4% 68% -2.30
South Korea 1.0% 1.9% 1.5% -0.4% -1.6% 37% 4.70
China 1.6% 1.4% 4.2% 2.8% -4.2% 51% 0.40
Poland 0.8% -1.1% 1.5% 2.6% -0.4% 49% -0.70
Chile 0.8% -0.3% 2.0% 2.3% -1.7% 26% -3.10
South Africa 3.1% 2.2% 6.5% 4.3% -4.4% 56% -3.60
Colombia 1.4% 0.5% 4.3% 3.8% -3.1% 51% -3.80
Brazil 0.4% 2.1% 5.5% 3.4% -7.1% 77% -0.77
EM Avg. 1.2% 2.1% 5.0% 3.0% -2.6% 45% -0.20

(Trading Economics)

Here we see a far different picture. These currencies have stronger GDP growth, positive real yield and much lower debt to GDP. Of course, the fiscal deficit and negative current account balances are a problem, but they exist due to the highly developed world denominated external debt these countries have following QE1-3.

After that shortage is closed, I expect the value of these currencies to rise significantly over the course of a few years.

The Bottom Line

For a long-term investor, CEW looks like a good buy. For a short- to medium-term investor like myself, it may be best to hold off and wait for the U.S. dollar to stop rising. Likely, this will also come with a bottoming and potential rise of wage inflation and a top in short-term bonds. In my opinion, we are very near this occurrence.

Here is a chart of these metric over the past few decades:

(Federal Reserve Economic Database)

As you can see, inflation expectations and short-term rates appear to be falling, while the trade-weighted U.S. dollar is back at its 2001 peak. That said, inflation expectations are falling largely due to a drop in commodity prices. Wage inflation, which drives long-term inflation, continues to march higher and will eventually force the Fed to stop cutting rates. When investors finally realize this, I expect the U.S. dollar to lose steam.

In summation, I expect CEW to be a great low-volatility dollar-hedged investment after a few months from now when the dollar reverses and EM currencies begin to rally.

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Disclosure: I am/we are long UUP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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