The U.S. dollar index (DXY or USDX) allows you to predict changes in the currency market. It's a measure of the value of the U.S. dollar relative to a basket of foreign currencies often referred to as a basket of U.S. trade partners' currencies. The index started in 1973 with a base of 100 points, shortly after the Bretton Woods system collapsed. One of the reasons for this was U.S. President Richard Nixon's decision to stop pegging the U.S. dollar's value to the price of gold.
Further, the value of the index was compared relative to the accepted base value of 100 points. After the Bretton Woods system ended in 1973, most countries allowed their currencies to float. The U.S. dollar index was used to determine how much the dollar was worth. The index is currently calculated by factoring in the exchange rates of six major world currencies, which include the Euro (EUR), Japanese yen (JPY), Canadian dollar (CAD), British pound (GBP), Swedish krona (SEK), and Swiss franc (CHF).
Factors affecting the U.S. dollar index
USDX can be affected by both changes in the Federal Reserve's monetary policy and shifts in market sentiment. The main factors driving the index are:
U.S. Money Supply. An increase in the supply of dollars results in the currency's depreciation. At the same time, a weak dollar does not mean the weakening of other currencies since the increased emission, in this case, will not affect the dollar in any way.
Fed's key interest rate. In this regard, we need to consider how attractive in terms of investment are dollar-denominated assets. These are, first of all, the government-issued securities (Treasuries). An increase in the interest rate leads to an increase in their yield, all other things being equal, which implies a possible change in the market value of bonds. If the treasury yield rises, government securities become more attractive to foreign investors who will need to exchange their national currency for U.S. dollars to invest in Treasuries. As a result, it creates more demand for dollars, and the currency strengthens. The dollar index also rises.
The attractiveness of the U.S. economy to foreign investors. Against the backdrop of a rising stock market and GDP growth, government measures to keep inflation at bay, decreasing unemployment and other important factors, international investors seek to invest in the stocks of successful American companies. For this purpose, they acquire dollars, which leads to an increase in demand, the strengthening of the U.S. dollar, and the growth of USDX.
Euro supply and demand. The U.S. dollar index comprises 50% of the euro/dollar exchange rate. Therefore, almost everything related to the euro affects the dollar as well.
DXY: what to expect in the coming months
The markets are currently driven by high inflation and geopolitical risks. These factors have already caused a major selloff in the North American stock market. At the same time, fears that the GDP growth in the euro area will slow down due to a possible war in Eastern Europe and rising energy prices pushed the euro back to the values it traded after the February meeting of the ECB.
Demand for the dollar remains on the back of rising yields on the 10-year Treasury notes, which are now trading at their January 2020 highs. This growth was driven by increased consumer spending due to rising fuel prices and a recovery in car sales.
Also, the U.S. dollar is bolstered by the projections that the Federal Reserve will increase interest rates up to seven times over the course of 2022. The Fed was urged to do this by several large investment banks, concerned that commodity prices keep surging.
The Kansas City Fed President Esther George expressed support for a more "gradual" approach. According to her, a quick transition to a neutral rate is unreasonable, given the uncertainties around the pandemic effects and other factors.
So what to expect from DXY and the dollar? If the conflict between Russia and Ukraine doesn't escalate into a war, and it most likely won't, the euro will continue to rise since the energy crisis will recede. On the other hand, the market has already priced in the Fed's aggressive monetary policy. If the U.S. regulator starts to make changes to its rate hike schedule, ruining the futures market projections, the euro will also go up. If you have long positions in the EUR/USD pair in the 1.13-1.1315 area, we recommend keeping them until March.
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