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The ETF to Own If Nations Ditch Dollar Pegs

The recently listed Barclays Asian and Gulf Revaluation ETN (PGD) could turn out to be a unique product -- it's tied to currencies that are pegged to the U.S. dollar, or rather, managed to stay within a band around it.

An investment PGD is basically a bet that some dollar-pegged currencies will release their pegs to help combat inflation pressure.

At first glance, it would seem this fund could not go down in price.

Managing currencies so as to have a fixed exchange rate or a narrow band is done not because those currencies are weak, but because they are potentially too strong. If the currencies were allowed to free-float, they would go up against the dollar too fast, which would cause problems with regard to competitiveness which would hurt demand for these countries U.S. exports.

PGD provides equal weighting to the Saudi riyal, UAE dirham, Hong Kong dollar, Singapore dollar and the Chinese yuan. The Sing dollar and the yuan are allowed to float in a narrow band, and both currencies have strengthened by about 10% over the last year with expectation that they will continue to inch up against the dollar.

The other three currencies are pegged, which creates strains in terms of inflation for those countries. In order to successfully manage the currency to their desired effect they have to keep their interest rates artificially low. If investors or speculators could buy riyals at a higher yield than the greenback with no threat of adverse currency movements, it would create a riskless carry trade, flooding the market with riyal buyers.

That would make it much more difficult, if not impossible, to maintain the peg or band.

Keeping interest rates too low for too long, of course, leads to rising prices. Earlier this year, the CPI in Saudi Arabia clocked in at 8.7%, with concerns that it will hit double digits later in the year. The UAE and Hong are also dealing with above-average inflation rates.

Government officials in those countries have vehemently denied that they will break the peg to relieve inflation pressure.

And that is what this ETN is all about. It's a bet that in fact these countries will break their pegs and that Singapore and China will allow for greater currency flexibility. The case for breaking the pegs boils down to a simple premise: At some point, these economies (Singapore less so than the other four) will overheat with extreme consequences, stemming from runaway inflation.

If that scenario doesn't seem plausible to you, then you shouldn't buy the fund.

If you think the free-float scenario holds water and you are a bit of a speculator, then while you wait, you will receive a modest monthly interest payment based on prevailing rates after paying a 0.89% expense ratio.

If the currencies are allowed to truly float freely, PGD could go up a lot. The yuan has been allowed to partially float for almost three years and in that time it has strengthened by 15%. A full float could result in a larger move than that. This would no doubt trigger reactions in other markets which is part of the argument against this happening but for now PGD is the way to capitalize on this.

Because the currencies are being held back from natural price appreciation, there is an element of this being a one-way trade. That potentially becomes a dangerous assumption where currencies and inflation rates are concerned.

If PGD does what is expected, there will be very little movement day to day. Over time it might creep higher, with the yuan and the Sing dollar with big moves coming on the news of any actual de-pegging.

This is a bet on a specific outcome that for now is being denied by all concerned parties - and, to a lesser extent, that the trends in the yuan and the Sing dollar will continue in the same direction as over the last few years.

At the time of publication, Nusbaum had no positions in the named securities, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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