- Why is DXY Index important?
- The DXY reflects dollar strength or weakness and is a pricing mechanism for many commodities
- How is the DXY Index Calculated?
- The dollar index reached an almost two-decade high in March 2020
- A falling knife led to price consolidation
- Bearish sentiment is a dark cloud over the dollar for three reasons
Why is DXY Index important?
The US dollar is the most widely used and recognized currency worldwide. Central banks and governments hold US dollars as the primary exchange asset of their foreign exchange reserves. The dollar is the world’s reserve currency.
Reserve currencies are liquid, making them the foreign exchange instruments of choice for central banks and financial institutions for settling international transactions. Settling cross-border obligations with a reserve currency eliminates the need to exchange a country’s currency for each transaction.
The US dollar is the leading reserve currency because of the long history of political and economic stability in the US, the world’s leading economy. The dollar index (DXY) trades in the futures market on the Intercontinental Exchange (ICE) and the over-the-counter market between foreign exchange dealers.
The DXY reflects dollar strength or weakness and is a pricing mechanism for many commodities
Commodities are the raw materials that feed, clothe, power, and shelter the world. Production is a local affair in areas where the earth’s crust is rich in ores, minerals, metals, and energy. Agricultural products require suitable climates and available water supplies. Consumption is ubiquitous as people worldwide require essential commodities.
The pricing benchmark for most commodities is the US dollar because of its liquidity, stability, and role as the leading reserve currency. Local production costs and consumer prices may in various currencies, but wholesale supplies use the US dollar as the means of exchange. Over time, a rising dollar is typically bearish for commodity prices, while weakness in the reserve currency is a bullish factor. A strong dollar makes local production expenses fall, allowing foreign producers to sell output at lower prices and vice versa.
How is the DXY Index Calculated
The dollar index measures the US currency against other reserve currencies. Since the euro is the second-leading reserve currency, it has the highest weighting in the dollar index.
The dollar index is calculated according to the following formula of currency pairs:
The six currencies that comprise the dollar index are freely traded foreign currency instruments from politically stable countries. There is no regularly scheduled rebalancing or adjustment in the dollar index. The ICE exchange monitors the index methodology. The index calculation occurs in real-time from a multi-contributor feed of the spot prices of the Index’s components.
The dollar index reached an almost two-decade high in March 2020
In March 2020, at the height of the risk-off price action caused by the global pandemic, the dollar index spiked higher. The US dollar’s role as a reserve currency makes it a safe-haven during turbulent market periods. Source: CQG
As the chart highlights, the ICE dollar index rose to a high of 103.96 in March 2020, the highest level in eighteen years since 2002. While the index exploded higher during the week of March 16, it turned lower the next week.
A falling knife led to price consolidation
The dollar index entered a bear market after reaching its highest level in nearly two decades. Source: CQG
As the weekly chart illustrates, the index moved from an eighteen-year high to its lowest level since February 2018 as it fell steadily through 2020 and into early 2021. The most recent low was at 89.165, only 1.015 above the early 2018 bottom, which was the lowest level since late 2014.
Interest rate differentials play a leading role in the value of one currency versus another. The short-term Fed Funds rate dropped to zero percent as the financial fallout from COVID-19 gripped markets, narrowing the rate difference between the dollar and the euro currency. As the yield benefits of the dollar declined, it sent the US currency lower.
Moreover, as Europe settled the Brexit issue in late 2020, it lifted the cloud of uncertainty hanging over the euro and British pound. The two currencies account for 71.2% of the dollar index.
After dropping from 103.96 to 89.165 or 14.2% in nine months, the dollar index has traded in a narrow range. Source: CQG
The daily chart shows that the ICE dollar index futures contract has traded between 89.165 and 91.605 in 2021, a narrow 2.44 range after falling 14.795 points. The index remains not far from the low, but it is consolidating and has yet to challenge its critical technical support level at the 88.15 low from February 2018.
Bearish sentiment is a dark cloud over the dollar for three reasons
The trend in the dollar index remains bearish since the March 2020 multi-year high. Three compelling factors are weighing on the dollar as it consolidated near the downside target at 88.15.
- Short-term US interest rates remain only 50 basis points higher than short-term euro deposit rates. The narrow differential continues to support the euro as the yield difference collapsed from pre-pandemic levels.
- The US Fed continues to inject record liquidity into the financial markets, increasing the US money supply. Government stimulus to stabilize the economy has caused the US deficit to soar over the $28 trillion level. The tidal wave of liquidity and tsunami of stimulus weigh on the dollar’s purchasing power.
- The technical trend in the dollar remains lower. The trend is always your best friend in markets as it reflects the wisdom of the crowd. Crowds tend to make better decisions than individuals.
The dollar remains the world’s reserve currency, but that does not mean it will not continue to lose value versus other world currencies. A break below the February 2018 88.15 low in the dollar index could cause technical traders and speculators to pile in on the index’s short side. Meanwhile, central banks, monetary authorities, and governments tend to manage the foreign exchange market via coordinated intervention that provides stability by reducing volatility. Currency trends can last for prolonged periods. At the beginning of March 2021, the dollar’s trend remains lower.