By Caitlin Ostroff 

This year's decline in the U.S. dollar is drawing investors back into a practice that they had eschewed for some years: Borrowing the greenback to buy riskier assets in what is known as a carry trade.

A number of investors are pursuing higher returns by buying overseas assets. Investment firm Ashmore Group, for instance, sold the dollar to add local-currency government bonds from Mexico, Indonesia and Brazil to its portfolios, according to Jan Dehn, head of research.

The dollar is being used to fund such trades after a drop in U.S. interest rates this year made it less attractive for investors to hold dollar-denominated assets. With the Fed pledging to keep U.S. rates near zero for the foreseeable future, it may stay that way for a while.

The Fed's purchases of corporate and government bonds has also sent yields tumbling. Treasurys lost much of their allure as a store of value when real yields dropped into negative territory with the expected rate of inflation climbing. That has left investors facing the prospect of losing money if they hold government bonds until maturity.

Investors are now turning to bonds outside the U.S. that offer positive yields when adjusted for inflation.

Mr. Dehn expects the dollar to weaken in the coming years because the economic recovery is likely to be faster outside the U.S. He is not alone. Speculative bets that the currencies of the Group of 10 leading industrial countries will appreciate against the dollar are at a two-year high, according to data compiled by RBC Capital Markets.

The ICE U.S. Dollar Index, which tracks the greenback against a basket of currencies, has already fallen 2.3% this year, putting it on track for its worst performance in three years.

A weaker dollar would help the U.S. economic recovery, said Jane Foley, head of foreign-exchange strategy at Rabobank, even though the U.S. imports more than it exports. It would make U.S. exports cheaper for buyers, increasing the competitiveness of U.S. goods and helping offset the pain of a higher import bill, she said.

The growing use of the dollar in funding carry trades marks a shift in attitude among investors, who for some years have favored the Japanese yen over most other currencies. The euro also grew popular over the last couple of years with the European Central Bank taking its policy rates into sub-zero territory. Negative interest rates mean investors get paid to borrow money.

In contrast, the dollar grew less attractive as a funding currency between 2015 and 2017, when the Fed increased interest rates. This year, the difference between interest rates in the eurozone and the U.S. has shrunk.

For carry trades, investors look for currencies that are not just backed by low interest rates, but are also likely to be stable or to weaken. This can increase their profit when the trade is closed.

Vasileios Gkionakis, head of foreign-exchange strategy at Swiss private bank Lombard Odier, thinks the dollar is still overvalued by 10%-15% and is betting on a further decline over the coming year. He plans to use the greenback as a funding currency to bet on the strengthening of emerging market currencies in Asia, including the Chinese yuan, the South Korean won and the New Taiwan dollar.

Stuart Edwards, a U.K.-based fund manager at Invesco, also expects the dollar to weaken, particularly given the Fed's recent guidance on rates. "It's very difficult to bet against the central banks," he said.

Mr. Edwards has used the dollar to buy Mexican peso-denominated government bonds. The peso has gained 13.1% from its March lows, and offers a return of about 2.25% over the next year, according to Goldman Sachs.

But not all investors are convinced that the dollar will continue weakening. Some are betting that it will strengthen, given the possibility of a close U.S. presidential election and higher Covid-19 infection rates during the winter.

If the dollar strengthens, that could cause investors to close their positions and buy back the dollar, adding to the greenback's strength. Just last week, the ICE U.S. Dollar Index rose 1.9% amid concerns about the economy's uneven pace of recovery.

Another stock market rout this year could help the dollar strengthen, said Zach Pandl, co-head of global foreign exchange, interest rates and emerging markets strategy research at Goldman Sachs.

"If the global economy were back in recession, that would tend to be positive for the dollar," said Mr. Pandl. "The dollar is still a safe haven asset, and when we see large equity drawdowns, the dollar tends to appreciate."

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com

(END) Dow Jones Newswires

September 29, 2020 05:11 ET (09:11 GMT)

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