Introduction
There’s no doubt that the dollar index plays a dominant role in the financial markets, in which it controls 88% of transactions in the foreign currency market and all commodities such as oil, gold, and industrial metals priced through the U.S. The dollar’s daily changes have major effects on many other asset classes like commodities, precious metals, bond, and stock markets.
What Is the U.S. Dollar Index (DXY)?
The US dollar index (symbol: DXY) provides a general indication of the international value of the US dollar and it is a measure of the value of the dollar relative to its most significant trading partners. The dollar index is calculated by taking the geometric weighted average of the dollar’s value against a basket of six major world currencies and is calculated by taking the product of each currency spot rate raised to the corresponding weight according to the following formula:
Figure 1
The dollar index component currencies and their weightings are: Euro (57.6 %); yen (13.6 %); British pound (11.9 %); Canadian dollar (9.1 %), Swedish krona (4.2 %); and Swiss franc (3.6 %)
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Bloomberg Dollar Spot Index
The Bloomberg Dollar Spot Index (BBDXY) tracks the performance of a basket of 10 global currencies against the U.S. dollar. Its composition is updated annually and represents a diverse set of currencies that are important from a global trade and liquidity perspective.
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Interpreting and Trading the U.S. Dollar Index (DXY)?
An index value of 120 suggests that the U.S. dollar has appreciated 20% versus the basket of currencies over the time period in question. Simply put, if the USDX goes up, that means the U.S. dollar is gaining strength or value when compared to the other currencies. Similarly, if the index is currently 80, falling 20 from its initial value, that implies that it has depreciated 20%. The appreciation and depreciation results are a factor of the time period in question.
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The main fundamental factors affecting the dollar index are:
- The US trade deficit
- US, Japanese, Canadian, and European interest rates and bond yields
- CPI inflation
- Quarterly gross national product (GDP)
- Nonfarm payroll figures
Interest Rates and Dollar Index
Interest rates in the United States of America. The higher the U.S. interest rates compared to the interest rates in the rest of the world, the higher the demand for the U.S. dollar in order to get higher yields through the U.S. bond market. As shown in figure 2 the relationship between DXY and Interest rates during the last cycle of raising interest rates in 2018 and 2019.
Figure 2
How to trade using DXY?
As indicated above, the US dollar is the most important global currency, so the US dollar index must be analyzed before making any decision on whether to trade in the currency, commodity, stock, or bond market. If the dollar is weak, we will see a lot of strength in other currencies such as the euro and the pound and we will see strength in the commodity markets where most commodities will rise against the dollar due to its depreciation, and U.S. shares will rise as all traders outside the United States will get the advantage of the fall in the value of the dollar to buy more shares.
The Relationship between DXY and Forex Market
The dollar index moves against the euro and therefore in the event of the beginning of the rise of the index the euro must be expected to fall and vice versa, so knowing the direction of the dollar index, we can buy or sell the euro as shown in figure 3. When the DXY broke below its weekly support level in July 2020, that was a good buying signal for the Euro currency. When DXY formed a double bottom in September 2021 that was a good selling opportunity for the EURO.
In figure 4, when the DXY formed a double bottom in September 2021 that was a good buying opportunity in USDJPY Pair
Figure 3
Figure 4
The relationship between DXY and Commodities
All commodities are denominated in us dollars so studying DXY chart will be very useful in determining the commodities market cycle.
1. The relationship between the DXY and Oil Market As shown in figure 5 major Crude tops and bottoms coincide with the tops and bottoms of the DXY
Figure 5
2. The relationship between the DXY and Precious metals
There is always a negative correlation between the DXY and precious metals gold and silver so the strength of the DXY will always be bad news for gold and silver. As shown in Figures 6 and 7 the relation between DXY and Gold.
Figure 6
Figure 7
figure 8 shows the relationship between the DXY and Silver. When DXY changes its trend there will be a new trend in silver. When DXY broke below its support level in July 2020 that was a good buying opportunity in the silver market.
Figure 8
The relationship between DXY and Stock Market
DXY has a negative correlation with the stock market as shown in figure 9. When DXY moves in downtrend search for buying opportunity in the stock market
The Dollar Smile Theory
Stephen Jen, a former economist at the International Monetary Fund and Morgan Stanley, who now runs a hedge fund and advisory firm Eurizon SLJ Capital in London, came up with a theory and named it the “Dollar Smile Theory. His theory depicts three main scenarios directing the behavior of the U.S. dollar
Scenario #1: USD Strengthens Due to Risk Aversion
Figure 9
which causes investors to flee to “safe haven” currencies like the U.S. dollar and the Japanese yen. The investor will buy up “safer” assets like U.S. government debt (“U.S. Treasuries”) regardless of the condition of the U.S. economy. In order to buy U.S. Treasuries though, you need USD, so this increased demand for USD (to buy U.S. Treasuries) causes the U.S. dollar to strengthen.
Scenario #2: USD Weakens to New Low Due to Weak Economy
Weak economic fundamentals can force the dollar to drop to a new low. The possibility of interest rate cuts also weighs the U.S. dollar down
Scenario #3: USD Strengthens Due to Economic Growth
The dollar appreciates due to economic growth. In other words, the Greenback begins to appreciate as the U.S. economy enjoys stronger GDP growth and expectations of interest rate hikes increase
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Conclusion
US Dollar will affect every trader in the financial market whether you trade in forex, stock market or commodities so before committing any money into the market every investor must know first what is dollar index doing?
The content published above has been prepared by CFI for informational purposes only and should not be considered investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.