How Will the US Dollar Perform in 2024? A Closer Look into the US Dollar Index

At the start of the New Year in 2024, the price of the US dollar underwent a trend reversal and surged to a two-week high of around 102 points, as a result of various factors such as geopolitical tensions, the Federal Reserve's stance, and economic data.

The US dollar index holds significant importance as a crucial indicator in the financial market. Thus, in this edition, we will discuss the correlation between the US dollar and the market.

• What is the US dollar index?

• History of the US Dollar Index

• Why is the US dollar index important in the financial market?

• What factors influence the US dollar index?

• Summary

The US dollar index, also known as USDX or DXY, is an indicator that gauges the value of the US dollar in relation to a basket of foreign currencies. It is maintained by the Intercontinental Exchange (ICE), and its futures contract is a significant benchmark for the value of the US dollar internationally, widely recognized for currency trading worldwide.

The "basket of currencies" definition comprises not only the US dollar but also six other major global currencies with varying weights.

These include the Euro (57.6%), Japanese Yen (13.6%), British Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%), and Swiss Franc (3.6%).

The US dollar index is compiled by multiplying the respective spot exchange rate of each currency by its corresponding weight.

The US dollar index's composition of the aforementioned countries can be traced back to a historical context.

In 1944, the US committed to fixing the value of the US dollar to a set amount of gold as part of the Bretton Woods system. This agreement prompted countries worldwide to link their currency values to gold to maintain currency stability and prevent unfair competition.

However, during the 1960s, the US spent significantly on military expenses, causing a surge in currency issuance. This inflation, coupled with fiscal deficits, decreased the credibility of the US dollar, leading countries such as France to demand gold in exchange for US dollars. This demand resulted in a significant decrease in US gold reserves, ultimately leading to President Nixon's announcement of decoupling the US dollar from gold in 1971, and the collapse of the Bretton Woods system.

As a result, the Federal Reserve established a composite index in 1973 to measure the average value changes of the US dollar, leading to the creation of the US dollar index.

The index comprises ten currencies, representing the primary trading countries in the world at that time, the Group of Ten (G-10). The six member states of the European Community tied their currencies together to float against the US dollar. The euro became the legal currency in 1999, replacing five of the currencies, including the Belgian franc, Dutch guilder, French franc, German mark, and Italian lira.

It is beyond doubt that the US dollar index occupies a dominant position in the foreign exchange market, with US dollar index futures traded on the ICE platform for 21 hours a day controlling 88% of the market.

1. The Strong Correlation with the Foreign Exchange Market

Regarding the US dollar index's correlation with the foreign exchange market, it comprises six currencies, and changes in the other five currencies in the index, besides the US dollar, will impact the index's rise and fall.

A rise in the US dollar index indicates the US dollar's appreciation against the other currencies in the index, such as a rise from 100 to 120, representing a 20% appreciation against the basket of currencies. Conversely, if the index falls from 100 to 80, it means that the US dollar has depreciated by 20%.

Currently, the euro accounts for the largest share of the US dollar index at 57.6%, and fluctuations in the euro exchange rate against the US dollar significantly affect the index's trend. A weak US dollar often leads to a considerable strengthening of the euro.

A strong negative correlation between the US dollar and the euro is visible in the graph below. Credit Financier Invest suggests that investors can use technical analysis to identify potential buying and selling points for the euro by monitoring the US dollar index's trend. For instance, investors could have bought the euro in July 2020 and sold it in September 2021.

2. The Negative Impact of US Dollar Appreciation on International Trade

Looking at it from a trade perspective, US dollar appreciation causes the prices of US goods and services in the global market to increase. This prompts other countries to reduce their imports from the US, resulting in declining US exports. Conversely, the depreciation of other countries' currencies relative to the US dollar can lead to cheaper imports from the US. This situation tends to result in a decrease in exports and an increase in imports, leading to a rise in the US trade deficit.

A high trade deficit means that the US needs to borrow significant amounts of money to pay for the deficit, which may lead to a large supply of currency, ultimately causing the US dollar to depreciate.

For other countries, US dollar appreciation also presents various problems. For instance, it makes the cost of importing US goods more expensive, indirectly affecting the production and transportation costs of some companies in manufacturing, logistics, and other industries, resulting in decreased profits. Ultimately, these costs are often passed on to downstream consumers, leading to an increase in the prices of goods and services. In the worst-case scenario, it can cause inflation and even a slowdown in GDP.

3. The US Dollar is at the Core of the Commodity Market

Commodities such as gold, oil, corn, soybeans, and wheat are traded globally and priced and settled in US dollars. Therefore, analyzing the US dollar index is helpful in determining the commodity market cycle.

When the US dollar appreciates against other currencies, US dollar-priced commodities become expensive, suppressing overall demand for commodities.

However, not all commodities are priced in US dollars; some are priced in other currencies. At this point, US dollar-priced commodities must lower their prices to match global competitors. Conversely, if the US dollar depreciates, we will likely see a strong trend in the commodity market, and most commodities will appreciate against the US dollar exchange rate.

Moreover, from the perspective of the intrinsic value of commodities, the negative correlation between the US dollar and commodities makes sense. This is because all tangible assets such as commodities have intrinsic value, and when the US dollar changes, this intrinsic value needs to be re-priced in US dollars.

For example, when one ounce of gold is worth $2000, the intrinsic value of gold does not change when the US dollar appreciates. The amount of US dollars needed to purchase gold decreases, so the price of gold needs to decrease to match the appreciating US dollar. This is also why we see a negative correlation between the US dollar and precious metals. When the US dollar rises, the prices of gold and silver often fall.

4. The Relationship between the US Dollar and the Stock Market

The relationship between the US dollar index and the stock market is a topic of debate, as some claim it is positively correlated while others argue it is negatively correlated or unrelated. This is easily understandable because the stock market is influenced by multiple factors, and the US dollar is just one of them.

For instance, over the past 20 years, the S&P 500 index has had approximately a 40% chance of rising whenever the US dollar appreciates. Theoretically, since purchasing stocks requires US dollars, an increase in the US dollar would necessarily boost the US stock index's value. In other words, foreign investment plays a vital role. As more investors pour money into US stocks, they must first buy US dollars, leading to an appreciation of the index.

Similarly, from a theoretical standpoint, there should also be a certain link between the US dollar and foreign stock markets. When the US dollar depreciates, it is likely that the euro or other foreign currencies will appreciate, resulting in higher returns in foreign stock markets. US investors will then view this as an opportunity and flock to invest in foreign stock markets, resulting in a large influx of funds. This creates a significant number of buy orders in the overall market, leading to a rise in the stock market.

Stephen Jen, a former IMF and Morgan Stanley economist, developed the "Dollar Smile Theory" to explain the US dollar's behavior against other currencies.

According to the theory, the US dollar tends to appreciate when the US economy is either exceptionally strong or weak.

This is because of two primary reasons:

1. When the US economy is performing well

• Firstly, a stable economic environment attracts foreign investors to invest in the US, and they must purchase US dollars to buy these assets, leading to an appreciation of the US dollar.

• Secondly, during periods of robust GDP growth, the Fed may increase interest rates to prevent overheating the economy, leading to a rise in bond market returns and an increase in the attractiveness of government bonds. Foreign investors will increase their demand for the US dollar to purchase bonds, leading to an appreciation of the US dollar.

2. When there is chaos in the global financial market

• Apart from gold and US government bonds, investors view the US dollar as another excellent "safe-haven asset." During periods of economic uncertainty or "black swan events," investors tend to buy large amounts of safe-haven currencies like the US dollar and the Japanese yen, leading to an appreciation of the US dollar.

US dollar tends to weaken during a US economic recession

On the other hand, during a US economic recession, the US dollar tends to weaken. This is because a weak economy lowers investors' confidence in the US economy and assets, resulting in a decrease in the purchase of US government bonds and outflow of existing funds, leading to a decline in the US dollar exchange rate.

Additionally, weak economic fundamentals may force the Fed to adopt interest rate cuts, which suppresses the US dollar's value.

In summary, as the most influential global currency, the US dollar index can not only be used to analyze the foreign exchange market but also assess commodities such as oil, gold, and industrial metals priced in US dollars.

The behavior of the US dollar is influenced by a variety of factors, such as US interest rates, the state of the US economy, and the safe-haven properties of the US dollar during periods of risk aversion. Typically, US interest rates and the US dollar have a positive correlation. Similarly, the US economy and the US dollar often have a positive correlation as well. During times of risk aversion, the US dollar's safe-haven properties can cause the currency to appreciate.

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