How will the USD perform in 2024? In-depth study of the US dollar index

At the start of the 2024 New Year, influenced by factors such as geologic conflicts, Fed sentiment, and economic data, the dollar reversed its trend, rebounding to around 102 points to reach a two-week high.

AS AN INDISPENSABLE INDICATOR IN FINANCIAL MARKETS, THE DOLLAR INDEX IS OF GREAT IMPORTANCE. So, let's talk about the relationship between the dollar and the market in this issue.

• What is the US Dollar Index

• The origin of the US dollar index

• Why is the US dollar index so high in the financial markets?

• What are the factors that affect the dollar index

• Small knot

The Dollar Index (USDX or DXY) is an indicator that measures the value of the dollar against a basket of foreign currencies, maintained by Intercontinental Exchange (ICE). ICE USD INDEX FUTURES CONTRACTS ARE THE LEADING BENCHMARK FOR THE INTERNATIONAL VALUE OF THE US DOLLAR AND THE MOST WIDELY ACCEPTED INDEX OF TRADED CURRENCIES IN THE WORLD.

There is not only the dollar in the dollar index, as defined by the definition of “a basket of currencies”, in which there are six major world currencies, and the currencies they comprise have different weightings.

The composition and weighting of the dollar index: Euro (57.6%); Yen (13.6%); British Pound (11.9%); Canadian Dollar (9.1%), Swedish Krona (4.2%); and Swiss Franc (3.6%).

The final US dollar index is based on the real-time exchange rate of each currency multiplied by the corresponding weighting.

Why the dollar index is made up of several of the countries mentioned above is a bit of history.

At the time of the creation of the Brighton Forest System in 1944, the United States had promised the nations of the world that the dollar was fixed to standard gold, that is, $35 to exchange 1 ounce of gold. At that time, countries around the world pegged the value of their currencies to gold in order to keep their currencies stable and avoid unfair competition.

However, well into the 1960s, the war caused US military spending to increase, with large amounts of surplus currency. In the face of severe inflation and fiscal deficits, the creditworthiness of the dollar is in question. Countries such as France demanded to convert US dollars into gold, leading to a massive loss of US gold reserves.

Finally, President Nixon of the United States had to announce the decoupling of the dollar and gold in 1971, causing the Brayton forest system to collapse.

After that, the exchange rates of each country's currencies float freely and are no longer pegged to the US dollar. Therefore, the Fed needed to create a comprehensive index measuring the change in the average value of the dollar, which was created by the Fed in 1973 against this background. This is also the reason why the ICE USD Index took March 1973 as the base period (base value = 100), and what we now see are changes relative to the base period.

The dollar index was made up of 10 currencies, representing the world's major trading nations at the time — the Group of Ten (G-10). In this, the six member states of the European Community bundled their currencies together to jointly float the dollar. The euro became legal currency in 1999, replacing five of its currencies: the Belgian franc, the Dutch guilder, the French franc, the German mark and the Italian lira.

There is no doubt that the USD index dominates the forex market — USD index futures trade 21 hours a day on the ICE platform, controlling 88% of the forex market's trades.

1. USD Indices Related to Forex Market Strength

Just mentioned, there are six currencies in the dollar index, and changes in the value of the other five currencies besides the US dollar will affect the rise and fall of the US dollar index. That is, when we see the USD index go up, it means that the USD has appreciated relative to the other currencies in the index.

For example, the US dollar index rose from 100 to 120, indicating that the US dollar has gained 20% against a basket of currencies over that time. If the index falls from 100 to 80, it means that the US dollar depreciates by 20%.

Currently, the euro is the largest component of the US dollar index, accounting for 57.6%. Therefore, the floating of the euro against the US dollar rate tends to significantly affect the movement of the US dollar index. If the dollar is weak, we will usually see the euro strengthen significantly.

As shown in the figure below, we are able to see a strong negative correlation between the USD and the Euro. According to Credit Financier Invest, investors can find buy and sell points for the euro by observing the movement of the dollar index, combining technical analysis: for example, the signals to buy euros in July 2020 and sell the euro in September 2021.

2. Rising US Dollar May Have Negative Impact on International Trade

From a trade point of view, a rise in the US dollar will increase the price of US goods and services on the international market. Other countries reduce imports of goods and services from the United States, causing US exports to fall. In the same way, other countries' currencies depreciate relative to the dollar, and cheap prices will increase imports from the United States. With exports falling, the US trade deficit will rise as imports rise. Too high a trade deficit means that the United States needs to borrow a lot of money to pay for the trade deficit, and a large supply of currency can also cause the dollar to start depreciating.

For other countries, there are also many “problems” with the appreciation of the dollar. Let's think that the rise in the US dollar increases the cost of imports of US goods from other countries, which indirectly affects the production and transportation costs of some companies such as manufacturing, logistics, and leads to a drop in corporate profits. Ultimately, these costs are often borne by consumers who travel, which means that the price of goods and services will rise. In the worst case, inflation and even GDP will slow down.

3. The dollar is at the heart of the commodity market

Commodities are traded around the world, while the dollar is the most common pricing and settlement currency for commodities, such as gold, oil, corn, soybeans, and wheat, which are denominated in dollars. Therefore, studying the dollar index is very helpful in determining the commodity market cycle.

When the dollar rises against other currencies, dollar-priced commodities become expensive, suppressing the overall demand for goods. But there are not only dollar-priced goods on the market, but also items priced in other currencies. At this time, dollar-priced goods have to fall in price in order to match the prices of global competitors. This is also one of the reasons we see “weak commodity market prices”. On the contrary, if the USD depreciates, we are likely to see a stronger commodity market, where the exchange rate for most commodities against the USD will rise due to the depreciation.

In addition, this negative correlation between the dollar and commodities is also plausible from the point of view of the value of the commodity itself. This is because all tangible assets, such as commodities, have intrinsic value, and when the dollar changes, this intrinsic value needs to be re-priced in dollars.

For example, 1 ounce of gold is worth $2000, but when the dollar rises, the intrinsic value of gold does not actually change, and therefore the dollar required to buy gold decreases, so the price of gold needs to fall to match the rising dollar. This is also why we can see a “negative correlation between the dollar and precious metals”, where gold and silver prices tend to fall when the dollar rises.

4. There is a certain correlation between the dollar and the stock market

The market is concerned about the relevance of the dollar index and the stock market, with some saying it is positively related and negative and unrelated. In fact, this is not difficult to understand, since there are many factors that affect the stock market, and the dollar may be just one of them.

Taking the S&P index as an example, there has been about a 40% probability that the index has risen every time the dollar has risen in value over the past 20 years. In theory, since buying stocks requires dollars, it will cause the dollar to rise in value, which inevitably increases the value of US equity indices. Simply put, foreign investment is a big factor. As more and more investors put their money into US stocks, they need to buy US dollars first to buy US stocks, leading the index to appreciate.

Likewise, from a theoretical point of view, there should also be a certain relationship between the dollar and the foreign stock market. When the dollar depreciates, the euro or other national currencies are likely to rise, which means that foreign stock markets have higher returns, and American investors will certainly see this opportunity by flocking to the stock markets of other countries. The stock market rose as a result of a large influx of funds, with a large amount of buying in the overall market.

Stephen Zhan, a former IMF and Morgan Stanley economist, put forward a theory — that the US dollar tends to strengthen against other currencies when the US economy is extremely strong or weak. He named it the “Dollar Smile Theory.”

Simply put, the theory suggests that the dollar will rise in value in two cases:

1. A good time for the US economy to be fundamentally oriented

• On the one hand, U.S. domestic investors tend to invest more confidently in domestic assets. On the other hand, a stable economic environment will also attract foreign investors to invest in the United States, while overseas investors will need to buy dollars to buy these assets, which will cause the dollar to appreciate.

• With strong GDP growth in the US, the Federal Reserve may take interest rate hikes to prevent overheating of the economy. An increase in interest rates increases the cost of borrowing by banks, thereby increasing the interest rate. At this time, bond market yields will also rise, and the attractiveness of national bonds will increase, and foreign investors will need the dollar to buy bonds, which will eventually cause the dollar to rise in value.

2. When global financial markets are in turmoil or collapse

• In the eyes of investors, in addition to gold and US Treasuries, the dollar is an excellent “safe haven asset”. If there is a “black swan event” or at a time of economic uncertainty, investors tend to buy in large numbers of haven currencies such as the dollar and yen, ultimately causing the dollar to rise.

Instead, the theory suggests that the dollar weakens during the US economic downturn:

This is because economic uncertainty often leads to a decline in investor confidence in the US economy and assets. A decrease in investment attractiveness will not only lead to reduced purchases of US bonds, but also to an outflow of existing capital, which will cause the US dollar exchange rate to fall.

In addition, weak economic fundamentals may force the Fed to take interest rate cuts, and lower interest rates also weigh on the value of the dollar.

In summary, the dollar index is the change in value of the dollar relative to a basket of world currencies, and the dollar is the most important global currency, so the US dollar index is able not only to analyze the foreign exchange market, but also to analyze commodities such as oil, gold, industrial metals and other commodities priced by the dollar.

US interest rates and the US dollar are usually in a relationship between the rise and fall; the US economy and the US dollar are usually related; the hedging properties of the US dollar in a bullish mood will cause the dollar to rise.

If you feel like you learned how to analyze the dollar from this course, check out our Macro Interpretation's “Advanced” column for the latest market data!

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