What is the Dollar Index (DXY)? Why is it important for trading to pay attention to the DXY index?
The Dollar Index (DXY) is a measure of the strength of the US dollar.
Hello everyone!
The Dollar Index (DXY) is a measure of the strength of the US dollar. In today's market, there are various assets traded in US dollars, making the DXY an indispensable index for investors. Let's learn more about the DXY index in the following article.
And I'm Neo — Admin — Community Manager of Optimus Finance and Growth Marketing of LECLE Vietnam. Let's get started!
1. What is the Dollar Index (DXY)?
The Dollar Index (or U.S. Dollar Index) is a measure of the value of the USD (United States Dollar) compared to various other currencies.
These indices are composed of six different currency types, including EUR (Euro), GBP (British Pound), JPY (Japanese Yen), CAD (Canadian Dollar), SEK (Swedish Krona), and CHF (Swiss Franc). These are the currencies of countries/territories with significant trade relationships with the United States.
2. The method for measuring the Dollar Index
DXY is calculated based on the measurement of fluctuations in 6 different types of currencies with specific weights. The specific formula for calculating DXY is as follows:
DXY = 50.14348112 × EURUSD-0.576 × USDJPY0.136 × GBPUSD-0.119 × USDCAD0.091 × USDSEK0.042 × USDCHF0.036
So, when DXY rises, it means that the US dollar is being bought more compared to the basket of the 6 mentioned currencies, and vice versa. This implies an increasing demand for holding the US dollar under the influence of macroeconomic factors.
For instance, during financial or economic crises in other countries, DXY often tends to increase. This can be explained by the leading position of the U.S. economy, making the U.S. dollar a trusted currency and a safe-haven asset during times of crisis.
On the contrary, when there is a development that reduces expectations for the U.S. economy, funds tend to withdraw from the U.S. dollar, causing a decline in the DXY, as seen in the Dotcom bubble and the housing bubble crises as shown above.
3. The history of the formation and development of the Dollar Index
Following the collapse of the Bretton Woods system (which fixed the USD to gold at a rate of $35/1 ounce of gold), the U.S. and other countries needed to establish policies to regulate currency exchange rates. As a result, many governments opted for floating exchange rate policies.
Shortly thereafter, the U.S. Dollar Index was developed to monitor the strength of the USD as countries implemented floating exchange rate policies.
At its inception, the Dollar Index had a value of 100.
The Dollar Index started with a composition of 10 different currencies. After European countries formed the European Union with the common currency being the EUR (Euro), the currencies of Germany, France, Italy, the Netherlands, and Belgium were removed from the index and replaced with the EUR. This is also the reason why the EUR constitutes a significant weight of 57.6% in the index
4. How investors should monitor the DXY index?
In recent times, Bitcoin has exhibited an inverse relationship with the DXY index. When the DXY rises, the price of BTC tends to trend downward, and vice versa.
Therefore, it is highly likely that investors should closely monitor the dynamics and trends of the DXY and analyze them to make trading decisions.
Specifically, the DXY depends on fiscal and monetary policies from the U.S. Federal Reserve (FED) and the U.S. government, as well as the economies of other countries around the world.
For example, in the period from March 2022 to October 2022, when the FED raised interest rates significantly while other central banks did not keep pace with the FED, global funds shifted towards the U.S. dollar, leading to an increase in the DXY during this period.
Furthermore, the DXY also has a strong correlation with stock market indices (especially in the U.S. market). In the context of the increasing correlation between the Bitcoin and NASDAQ indices, the Dollar is an indispensable factor.
Currently, the United States remains the world's leading economy, and as a result, the performance of the U.S. dollar has a significant impact on various asset classes. Therefore, investors should also monitor the trends of this index to enhance their investment performance.
5. Significance and factors Influencing the Dollar Index
5.1. The significance of the Dollar Index.
The U.S. Dollar Index serves as a tool to assess the strength of the USD relative to the currencies in the index basket. When the Dollar Index rises, the USD tends to strengthen against the currencies in the basket.
In reality, major U.S. trading partners like China or Mexico do not make up the Dollar Index, so it no longer accurately reflects the current state of the USD in international trade relationships
Major organizations have also adopted more advanced index sets to accurately monitor and assess the strength of the USD. For example, the Federal Reserve (FED) now employs indices like the AFE Dollar Index and EME Dollar Index:
AFE Dollar Index (Advanced Foreign Economies): Measures the strength of the USD against developed economies.
EME Dollar Index (Emerging Market Economies): Measures the strength of the USD against emerging economies.
However, the U.S. Dollar Index is still widely used by investors as a relative assessment tool. This is because the currencies in the index basket still hold significant weight in the foreign exchange reserves of many countries and are widely accepted in international payment transactions.
5.2. Factors Influencing the Dollar Index
The fluctuations in the prices of the 6 mentioned currencies in relation to the USD will impact the Dollar Index. Changes in the financial economies of the U.S. and the mentioned countries can influence this index.
Several factors can be highlighted, such as:
Monetary Policy: Actions like raising interest rates will cause the Dollar Index to rise, as capital flows into the USD due to its higher interest rates, and vice versa.
Trade Balance: The trade balance reflects a country's currency demand. If other countries have a high demand for U.S. goods and services, it implies a higher demand for USD, causing the Dollar Index to rise, and vice versa.
Strength of the U.S. Economy: A strong U.S. economy with numerous investment opportunities will attract investment capital into the country. Additionally, the USD is an international reserve currency and a safe haven in times of turmoil, so the overall strength of the economy plays a significant role in bolstering the U.S.'s position.
6. Impacts of the Dollar Index
6.1. Impacts on the Economy in general
The fluctuations in the Dollar Index, while not exact, will influence the exchange rate trends of most countries. For any given country, when the Dollar Index is on an upward trend, there is a high likelihood that the country's currency will depreciate against the USD.
The appreciation or depreciation of the USD impacts the global economy. When the USD appreciates significantly, it directly affects international trade because the U.S. has the world's largest economy.
Apart from trade, exchange rate fluctuations also affect many other macroeconomic factors within a country, such as inflation, GDP growth, monetary policy, investment flows...
For example, in the case of Vietnam, an appreciation of the USD against the VND would result in the following impacts:
Imported raw materials and inputs would become more expensive, contributing to increased inflation.
Export-oriented businesses in Vietnam would benefit as the prices of goods exported to the United States would decrease, creating a price competitiveness advantage.
Foreign-invested enterprises in Vietnam (using USD as their base currency) would experience reduced profits, which could reduce the incentive for other companies to invest in Vietnam.
Many other aspects would be affected as well.
6.2. Impacts on asset classes
In addition to deeply affecting the economy, the Dollar Index also has an impact on the financial markets, as the United States is the country with the largest financial market in the world.
When the Dollar Index is on a strong upward trend, the prices of assets traded in USD tend to decrease. For example, this can be seen in stocks, particularly those tracked by the S&P 500 index.
Revenue from international markets for S&P 500 companies accounts for 29%, and for technology companies like Apple, Microsoft, Meta, Google, it's 59% (according to Goldman Sachs). Therefore, the upward fluctuations of the Dollar Index have a negative impact on international market sales, directly affecting stock prices.
Bitcoin and cryptocurrencies have recently had a close correlation with the S&P 500, so they too will be influenced by the Dollar Index.
Commodity is another example of the impact of the Dollar Index on asset classes.
The USD holds a significant weight in the foreign exchange reserves of many countries and is widely accepted in most international trade transactions. Therefore, the Dollar Index also influences commodity prices.
Typically, this relationship is inversed, meaning that when the Dollar Index is on an upward trend, it has a negative impact on commodity prices, and vice versa. However, a Citibank study has pointed out that the correlation between the USD and commodity prices is currently becoming less tightly linked.
In general, understanding the fluctuations of the Dollar Index and the underlying factors can provide investors with a comprehensive view of the money flow in the market.
7. Closing thoughts
The Dollar Index is a set of indices that measure the strength of the USD against other currencies. Although it no longer accurately reflects this, the Dollar Index is still used by many investors as a relative tool to determine the trend of money flow in the financial markets.
Given the U.S.'s leading position in the financial economy, the USD influences various asset classes. Therefore, monitoring the Dollar Index helps us enhance our investment performance.
What about your thoughts? If you want to know further about it, don’t hesitate to share it with us! 😀
This post is for educational purposes only. All materials I used were the different reference sources. Hope you like and follow us and feel free to reach out to us if there is an exchange of information. Cheers! 🍻
#dxyindex #dxy