The Dollar's Gains May Be Gone for Good

Everyone's celebrating about the bang-up job that Ben Bernanke and his colleagues at the Federal Reserve did in joining the global stimulus party. Stocks soared to new five-year highs last week, and with the Fed's news coming right on the heels of similarly bullish stances taken by the European Central Bank and the Chinese government earlier this month, it's looking increasingly likely that stocks will take a run at trying to set new all-time highs in the near future.

But beyond stocks, another part of the financial markets has seen a very different reaction from all the stimulus news. After an impressive run that took the U.S. dollar up to levels not seen in more than two years, the one-two-three punch of central bank and government intervention have knocked the greenback for a loop from which it may not recover for a long time.

Until recently, investors seemed convinced that the U.S. dollar was the least of all evils among major currencies. With the eurozone under attack from the sovereign debt crisis and the attendant pressure on Europe's entire financial system, selling the euro was one of the most popular trades in the currency markets. Meanwhile, fears of a slowdown in high-growth emerging market economies led to a drop in precious metals prices, hurting mining companies and therefore pushing currencies of resource-rich countries Australia and Canada down substantially. Both the Canadian and Australian dollars briefly fell below parity versus their U.S. counterpart, with Canada's currency remaining worth less than a U.S. dollar for a couple of months.

Greater optimism about economic prospects, though, put an end to the dollar's rise. And now, the provisions of the Fed's QE3 program include its intent to keep interest rates low at least through 2015. That essentially gives investors carte blanche to borrow U.S. dollars and invest them in higher-yielding currencies like Australia's or emerging currencies like Brazil's real. Moreover, with Europe appearing to be in better health, the euro has climbed above the $1.30 level and could easily see more gains.

Perhaps the most ironic thing is that a falling dollar is often good for shares of U.S. multinationals. During the recent period of dollar strength, a bunch of companies have cited its impact as hurting their results. (NYS: MMM) , for example, saw revenue fall almost 2% in its most recent quarter due to dollar strength, while (NYS: JNJ) also cited the dollar as part of its reason to cut its earnings guidance for the rest of the year. Even (NYS: ABT) , which has had a good run of growth lately, had to deal with negative currency effects holding back its results.

Of course, what's good for U.S. multinationals is bad news for foreign companies that have a lot of U.S. revenue. Unilever (NYS: UL) , for instance, states its financials in euro terms, but it gets a third of its sales from the western hemisphere, with a substantial amount of that revenue coming from U.S. consumers. A weaker dollar makes that revenue worth less in euros, hurting its bottom line.

Choosing stocks based on anticipated currency effects is one way to take a position on the future direction of the U.S. dollar, but it's not the only one. Currency ETFs let you profit directly from currency moves if you get the direction right. For instance, (NYS: FXE) tracks the price of the euro closely, with each share having a dollar value equal to just under 100 euros.

Don't expect currency ETFs to pay big yields, though. The ETFs make low-risk short-term investments, so while you may get the equivalent of what a bank savings account might pay in that country, it usually won't be a huge amount.

For most investors, dabbling in foreign exchange directly is a dangerous thing to do. With experts who spend all their time dealing with the forex markets, you'll face a steep learning curve if you want to try to beat them at their own game.

But in a global economy, foreign exchange plays a key role. Knowing how currency trends could affect the stocks you own will help you avoid big potential problems.

A weaker dollar helps U.S. companies in their quest to conquer the global economy. Find out more about three great prospects in the Motley Fool's popular special report "3 American Companies Set to Dominate the World." It's yours free just for being a Fool.

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Fool contributor Dan Caplinger has fun keeping his foreign currency when he gets back from trips. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Johnson & Johnson and Abbott Labs. Motley Fool newsletter services have recommended buying shares of 3M, Unilever, and Johnson & Johnson, as well as creating diagonal call positions in Johnson & Johnson and 3M and a bear put spread position in CurrencyShares Euro. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy works the whole world 'round.

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