Omicron Spread to Adversely Impact Dollar Strength and UUP, Temporarily Benefiting UDN

There is some uncertainty as to the U.S. Dollar (USD) performance against a basket of major currencies as from December, with, on the one hand, traders retreating from riskier currencies amid talk of interest rate hikes by central bankers, and concerns about the spread of Omicron cases on the other.

Looking at the one-year performance, the Invesco DB U.S. Dollar Index Bullish ETF (UUP) which track the U.S. dollar up against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and the Swiss franc is up by 6.26% while the inverse-tracking Invesco DB U.S. Dollar Index Bearish ETF (UDN) is down by minus 7.54%.

Source: Trading View

Now, if you are a Forex trader and have reasons to think that the U.S. dollar is going to fall, you can buy UDN, but it could also be beneficial to those looking to mitigate currency risk or protect against the possibility to be negatively impacted by variation in exchange rates between currencies. One example is a European company whose base currency is the euro with a U.S.-based business accounted in USD.

Thus, the company is susceptible to the fluctuations of the EUR/USD currency pair. Here, there is transactional currency risk corresponding to the possibility that the equivalent value of an invoice issued by a company is adversely affected by a change in the exchange rate. Then, there are also balance sheet risks whereby the assets or liabilities are adversely affected.

To address these risks, instead of using some complex and costly hedging strategy in the derivatives market making use of forward contracts or swap mechanisms, UUP and UDN, both carrying management fees of 0.75% can prove handy. Still, these instruments represent a cost for the company (or an individual trader) and it is important to find the right balance between full coverage and no coverage.

Coming back to the thesis, with a hawkish Fed planning interest rates hikes in 2022 and beyond, and the U.S. economy looking strong while the European Central Bank (ECB) taking longer to tighten monetary policy are positives for the USD. However, with the risks associated with Covid, especially the Omicron strain lessening (due to more infection rates not necessarily resulting in more hospitalization or death), there is less appeal for the USD as a safe-haven currency.

Thus, making a parallel with Dec 2019 to March 2020 when UUP gained more than 3% (brown curve below) as the number of Covid cases escalated and the WHO declared it to be a worldwide pandemic, the opposite should be the case in Q1 with the spread of Omicron making the dollar lose some of its luster in 2022.

Source: Trading View

Consequently, an investment in UDN, with the potential of gaining 3% makes sense, but bear in mind that its rise will be temporary, as learning from the past, the dollar should continue to prevail.

For this matter, the dollar started gaining as from October 2014 with the period before characterized by the U.S. actively carrying out quantitative easing (QE), which massively increased the quantity of money in circulation, in turn limiting the appreciation of its currency. This all changed from September 2014 when the ECB, in turn, resorted to QE (after initially prioritizing on long-term bank refinancing), resulting in a fall of the euro. For its, part the Fed ended up asset purchases in October 2014. These two events resulted in a strong dollar from this month (labeled in the chart above), with UUP rising and conversely, UDN falling.

This trend should continue as the dollar remains central to the Forex market as a trade currency. Alternatives like the euro or even commodity currencies like the Canadian Dollar remain strong but as regional currencies. Exploring further, Bitcoin still have to broaden their use as a medium of exchange in addition to a store of value before being in a position to rival the USD.