✅Why Be Interested?
The strong dollar has been getting a lot of attention lately. Some U.S. companies are blaming the strong U.S. dollar for lackluster earnings, while economists say it's helping the Federal Reserve’s ongoing fight against high inflation.
But how do you know when the dollar is strong or weak? That’s the job of the U.S. Dollar Index (DXY)
☑️What Is the U.S. Dollar Index?
The U.S. Dollar Index is a market index benchmark used to measure the value of the U.S. dollar relative to other widely-traded international currencies.
The Federal Reserve established the dollar index in 1973 to track the value of the U.S. dollar. Two years earlier, President Richard Nixon had abandoned the gold standard, which allowed the value of the dollar to float freely in foreign exchange (forex) markets.
Since 1985, the dollar index has been calculated and maintained by Intercontinental Exchange (ICE).
☑️The Dollar Index History and Makeup
The formula for calculating the value of the U.S. Dollar Index includes the dollar’s relative value compared to a basket of foreign currencies. Initially, it included the Japanese yen, British pound, Canadian dollar, Swedish krona, Swiss franc, West German mark, French franc, Italian lira, Dutch guilder, and Belgian franc.
Following the creation of the euro in 1999, the number of currencies was reduced and the formula for the dollar index was adjusted. Today, the basket includes just six currencies: the euro (EUR), Japanese yen (JPY), British pound (GBP), Canadian dollar (CAD), Swedish krona (SEK) and Swiss franc (CHF).
✅How Is the U.S. Dollar Index Used?
The USDX allows traders and investors to monitor the purchasing power of the U.S. dollar relative to the six currencies included into the index's basket.
Investors also use the dollar index as a litmus test for U.S. economic performance, particularly when it comes to imports and exports. The more goods the U.S. exports, the more international demand there is for U.S. dollars to purchase those goods. When demand for the dollar is high, USDX rises.
☑️Dollar Index Shortcomings:
The weightings of the currencies used to calculate the index were based on the United States’ biggest trading partners in the 1970s.
As a result, its calculation doesn't include emerging market currencies, like the Mexican Peso (MXN) or commodity currencies. It also doesn't include China’s renminbi (CNY), even though China is now the largest U.S. trading partner by a wide margin.
Therefore, the index may be less useful as an economic measure than in previous decades.
✅What Makes the U.S. Dollar Strong?
A combination of higher inflation, the Fed's aggressive tightening campaign and a global search for yield have all contributed to the strong dollar.
A strong dollar means other global currencies have been relatively weak, which exacerbates inflationary pressures and financial market volatility.
The Dollar Index can be used as a gauge of the Dollar strength or weakness, and it’s futures can be used to profit form Dollar moves without betting on any individual Dollar currency pair which provides diversification. However, the Index is somewhat outdated which needs to be accounted for when using it.
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