Why is the U$ Dollar Index so important?

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Why is the US Dollar Index (DXY) so important?

The Dollar Index, DXY, USDX, call it what you like, is a measure of strength of the USD against a basket of other currencies, in brief, it finds out the relative strength of the USD against a range of other economies and currencies, not just one, as is the case with each individual currency pair.

Investopedia states:

“The EUR is, by far, the largest component of the index, making up almost 58 percent (officially 57.6%) of the basket. The weights of the rest of the currencies in the index are – JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), CHF (3.6%). “

The way the DXY can be useful is that we look at it to determine the general direction of major currency pairs.  It is important to know though, that the DXY doesn’t dictate the move of any pair as it is a product of how each of the included pairs are performing against the USD.

What it can do however is to give an insight and a guide to how the USD (and to an extent how the US economy) is performing against the other currencies in the basket and thereby also guiding us how to play other currency pairs, not necessarily included in the basket, against the USD.

With the value of the USD against other currencies come a number of correlations which are general rules of thumb although as always in trading, not always 100% accurate.

Direct correlation can generally be found with US Interest rates and USD Based currency pairs

Inverse correlation is generally found with US Stock Indices and Precious metals.

So far there are no major surprises.  Looking at some external factors however makes the DXY more interesting. 

How are the economies of the world impacted by the value of the USD?

In the US, the value of the USD will not affect the oil price to consumers at all as a very large proportion of the world’s oil trade is USD denominated. Even if the share is slowly dropping due to incursions of the EUR, CHF and RNB as well as a smaller proportion of RBL, most trades are still done quoting USD per barrel.

Oil price dependency on USD strength

Bearing in mind that our economy is very much oil driven, an increase in USD value will increase the price of oil in all non-USD trading markets and increase the inflationary pressure in these markets.  It will also drive up interest rates, but it will help provide these economies with a competitive advantage when trading with the US as exported goods to the US will be relatively cheaper while US exports will be hit by relatively non-competitive pricing.  Interestingly, as a majority of foreign held debt is USD denominated, a stronger USD also leads to higher costs for countries and companies to service their debt if the value if the USD is rising.

A decrease in the value of the USD will have the opposite effect on the economy which at this time could be a big problem for the European and other world economies as the decreasing value of the USD is driving prices down, decreasing the competitiveness of the exporters and having a deflationary effect on the economy which is precisely what will hamper the non-US economies from recovery as their trade with the US or in USD denomination is of the utmost importance.

In the US a weaker dollar will have inflationary pressures on the domestic US economy as all imported goods will increase in price.  This may lead to an increase in USD interest rates in a bid to keep inflation under control, raising the cost of debt which at current debt levels can be devastating to the economy, domestically in the US and internationally.  Interestingly though, the weaker USD will stimulate exports from the US as US goods will be more attractively priced abroad.

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An additional factor is that as the USD is the reserve currency of the world and the other reserve “currency” is mainly gold. This usually makes gold increase in price when USD drops in value and vice versa, which you may not have considered!

Conclusion

As you can see, the DXY can tell us a lot about the world economy as a whole but it is not as straight forward as only looking at currency pairs as the economies of the world are tightly intertwined with the USD as the bond.  The fluctuation of the USD has both positive and negative effects on the world economies and the effects are largely self-stabilising as long as no major outside factor or influence disturbs the balance.  Keep an eye on the DXY when you are trading, it can help you identify opportunities and risks that you may not have thought of!

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