US Dollar Index
Established in 1973, the US Dollar Index (USDX) is an empirical measure of the value of US dollar against six other foreign currencies (fixed basket of currencies), with assignment of varying weights to respective currencies ie. Euro (EUR) 57.6 %, Japanese Yen (JPY) 13.60%, British Pound (GBP) 11.90%, Canadian Dollar (CAD) 9.10%, Swedish Krona (SEK) 4.20% and Swiss Franc (CHF) 3.60%. Before 1999, when Euro became a legal tender, USDX consisted of ten currencies-Deutsche mark, French franc, Italian lira, Dutch guilder, and Belgium franc in addition to JPY, GBP, CAD, SEK and CHF. To draw an analogy, the value of a stock index like SENSEX or NIFTY is computed on the basis of a basket of securities, each carrying a different weight, similarly value of USDX is arrived at through combination of six other foreign currencies.
Historical Background
After the end of WWII, delegates from 44 allied nations met in Bretton Woods, New Hampshire, United States in what is formally known as the United Nations Monetary and Financial Conference, to chalk out a strategy for international monetary management and stability. It was decided to adopt US Dollar as the central currency and peg all other currencies to USD, which in turn could be converted to gold at a fixed rate of USD 35 per ounce of gold. US guaranteed all countries that it would redeem USD held by them for gold. This came to be known as the Gold standard and prompted other countries to create USD currency reserves instead of gold. US issued USD denominated treasury bonds against its own gold reserves. But the Vietnam war (1955-1975) put a heavy drain on US exchequer forcing the Fed to print extra paper currency, thus weakening USD value. This prompted other countries to create pressure on US Government to convert their USD reserves into gold (under the Bretton woods agreement). Demand for gold became so huge that on 15th August 1971, the then US President Richard Nixon announced formal delinking of USD from gold. The collapse of Bretton Woods Agreement also led to abolition of system of fixed exchange rates of other currencies vis a vis USD
So although theoretically all currencies now followed a floating exchange rate system, but looking at the pre-dominance of USD in international trade, it was considered necessary to have an index which represented the intrinsic strength or value of USD, and USDX was born. In 1973, the US Federal Reserve (the Fed) created an official index (USDX or DXY) to keep track of the dollar's value. USDX was a composite index based on values of different currencies vis a vis USD with the currencies being given varying weights in the index depending on their trade relations with US. As stated above, USDX included individual European currencies which were substituted by Euro in 1999. Weights assigned to various currencies have remained unchanged since then.
It can be said that present day USDX does not represent the true value of USD as composite currencies like the Swedish Krona or Swiss Franc may no longer be pivotal for US trade while Chinese Yuan or Mexican Peso which are far more relevant today, do not have place in USDX.
USDX started at 100 and the value keeps on changing depending on relative strength or weakness of USD in international monetary system. The index touched an all-time high of 163.83 on 5th March, 1985 while it slumped to an all time low of 71.58 on 22nd April, 2008.
Trading in USDX
The index was initially devised and managed by the Fed, but now it is maintained and published by ICE (Intercontinental Exchange, Inc.). It is an American company that operates 12 global financial exchanges (including New York stock exchange) and 6 central clearing houses across nine different asset classes. Its headquartered in Atlanta, US and has an Indian office at Hyderabad.
USDX futures contracts are traded electronically on the ICE platform for 21 hours a day ie. from Sunday 18:00 hours Eastern Standard Time (EST) till Monday 17:00 hours EST and then from Monday to Friday 20:00 hours EST till 17:00 hours EST next day. The index is updated every 15 seconds. Futures have a quarterly expiry cycle every March/June/September and December. The index is also available for trading through Options or Exchange Traded funds (ETFs).
As
mentioned above, mean value of USDX is 100 and fluctuation below or above this
level denotes USD’s weakness or strength vis-à-vis the basket of currencies.
USDX value does not necessarily represent the US economic condition. USD is now
accepted as a global currency and USDX may fluctuate due to economic conditions
and monetary policies of the composite countries or global geo political
situation, as witnessed recently at the time of Ukraine conflict. Fluctuation
in supply and demand for USD at any given point of time may also affect USDX.
USDX
is considered as an important indicator of world economic health in so far it
shows the status of commodity markets (as they are mainly traded in USD) as
well as economies of participating countries whose respective currencies form
the USDX basket.
USDX
and the World
USDX
is an index similar to NIFTY / SENSEX or DOW JONES / FTSE 100 ,
the only difference is that instead of being an indicator of equities market,
it reflects relative strength or weakness of USD vis-à-vis world trade. The
index has been quite volatile during the current year 2022. It is currently
hovering at 104.35 (22/12/22) after having started the year at 94.63 (14/01/22)
and touching a 20 year high of 114.78 (28/09/22).
Current
USDX volatility can mainly be attributed to inflationary pressures in western
economies caused by high energy and food prices. Inflation rates in the US have
been around 7.50 % while in the UK, inflation has been hovering around 11 %.
These are highest levels since December 1981. A natural consequence of higher
inflation is an increase in interest rates, so as to curb consumption. To
counter inflationary trends in US economy, since March 2022, the US
Fed has raised interest rates by 375 basis points. Another consequence of an increase
in interest rates is that it makes the bond market relatively appealing
resulting into flow of funds to bonds and making the currency dearer.
Current
USDX volatility, primarily due to instability in US and other economies linked
to USDX, can be compared with the situation in 1970s. There was runaway inflation
with Americans
sporting "Whip Inflation Now" buttons on their jacket lapels. Fed had to increase rates to curb inflation,
leading to a surge in USDX which touched level of 163.83 in March 1985. Although the current situation
in 2022 is better than the inflation scenario in late 1970s or early 1980s, but
it is still the worst inflationary pressure, the US has faced in decades. This
has led to the US Fed continuously increasing policy rates. This is having an
impact on USDX also.
USDX
and India
The
current volatility in USD/INR parity, has brought increased focus on USDX.
Historically, any strengthening in USDX has resulted in weakness in INR. This
can be gauged from the events in past two-three months when the INR touched its
all-time low and USDX scaled its all-time high. The USDX inches up with
strengthening of USD which in turn is guided by an increase in interest rates
by US Fed. This hike in interest rates leads to a flight of capital from riskier
Emerging markets like India to stronger markets like the US, leading to
strengthening of USD against currencies of emerging markets. So INR and USDX
are in an inverse relationship whereby strength is matched by weakness in the
other.
The
other corollary of a rise in USDX / appreciation in USD is a simultaneous fall
in prices of precious metals like Gold. Investors liquidate investments in Gold
and park funds in USD making the latter dearer. A rise in USDX resulting in
strengthening of USD, makes imports costlier for India. Since India is heavily
dependent on import of crude, a rise in USDX /strengthening of USD increases
cost of imported crude. Elevated domestic fuel prices increase production costs
and create inflationary pressure in Indian economy.
A
movement in USDX therefore has consequences for Indian economy and requires a
watchful eye.
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