Ram: Hey, I was reading in the papers that the dollar index reached a 6-month high this week. What is it, actually?
Veena: Ha! The dollar index (DXY) measures the value of USD against a geometric weighted average basket of six major international currencies – Euro (57.6 per cent weight), Yen (13.6), British Pound (11.9), Canadian Dollar (9.1), Swedish Krona (4.2) and the Swiss Franc (3.6). It is calculated tick by tick based on the predefined formula for the index.
It was initially introduced in 1973 by the US Fed with a starting value of 100 after the Nixon government abandoned the gold standard. At that time, the basket had 10 currencies, and this was fixed based on countries with which the US had large trading relationships.
After the introduction of the Euro, some of the currencies of individual European countries were replaced with the Euro, resulting in six currencies as of now. It is now maintained by the Intercontinental Exchange, which offers futures contracts on the DXY.
Given the Euro was launched in 1999 and since then US trading relationships have further evolved, with China being one of the largest trading partners now, there may be a case for further changes in the basket to better reflect current times. But for now, this is what it is, and nevertheless, it is a very important tool to gauge the global economy and investor sentiment. It is keenly tracked by investors, traders, and economists.
Ram: Can you explain?
Veena: While there are numerous variables impacting asset/ currency prices, DXY strengthening could mean that globally investors are adding on to dollars in their portfolio. This could mean risk-off trade is taking hold as the dollar is globally viewed as a safe haven during times of uncertainties.
Whether it was the 2001 recession in the US that impacted global economies, the 2008 Great Financial Crisis, or the early stages of the Covid-19 crisis in 2020, when lockdowns paralysed the world, people flocked to the dollar. Each of these times, the DXY spiked.
On the contrary, when the global economy was booming and inflation was high in the US and emerging market investing was the big theme in 2007–08, the DXY reached an all-time low of close to 70 before spiking as the housing bubble burst.
However, it is important to note that we have not seen those kinds of spikes now, although their strength is now gaining attention due to the strange times we are in given the high inflation, high bond yields, and expected but elusive US recession.
Another thing to note is that while the DXY has moved up to around 105 now, it rallied to nearly 115 last year, which was a decade-high, as aggressive interest rate increases and the Russia-Ukraine war dampened risk sentiment. However, from there, it slid as risk-on sentiment returned, except for a spike again during the period of the Silicon Valley Bank crisis in the US and Credit Suisse collapse in March 2023.
Ram: Hmm…interesting. So it could be false alarm this time too?
Veena: May or may not be. We will know that only in hindsight! It’s not just the risk-on and risk-off sentiment it indicates; it also has many implications at the micro and macro level that you as an investor must take note of. While INR is not part of the DXY basket, DXY strength has correlated with INR weakness, and this could increase (imported) input costs for Indian companies, especially at a time when crude prices are increasing. Simultaneously, it is worth noting that precious metal prices are inversely correlated with DXY. Also at the macro level, continuing DXY strength can make the RBI’s inflation-fighting more difficult, while on the contrary, the US Fed would welcome it as it will make their inflation-fighting easier.
If you are an investor in US stocks, it is worth taking note that profits of US companies, especially tech companies that derive a significant part of revenue from outside the US, get negatively impacted. The strong DXY reduces the worth of their foreign earnings in other currencies. Last year when DXY was rallying, Morgan Stanley released an interesting report where they highlighted how for every 1 per cent rise in DXY, S&P 500 earnings are negatively impacted by 0.5 per cent
Thus there are multiple facets to it!
Ram: Hmm…interesting times ahead!