Dollar index: key factors affecting the instrument’s price

What does dollar index depend on

31-03-2020

The US Dollar Index (DX) is a popular instrument that demonstrates the value of the US currency against a currency basket. Its value helps to understand the average price of the basic reserve currency, and see the dynamics of the exchange rate, while keeping a close watch on whether the price of dollar is getting up or down.

The index basket consists of six currencies, namely Euro, Yen, Pound, Canadian Dollar, Swiss Franc and Swedish Krona Their weight is divided in the following manner: Euro with 57.6%, Yen with 13.6%, Pound with 11.9%, Canadian dollar with 9.1%, Swedish Krona and Swiss Franc with 4.2% and 3.6%, respectively.

Contents:

1. Dollar Index and What Does the Instrument Price Depend on
2. US Dollar: Pricing Specifics
3. How Does the Dollar Index Depend on the Euro
4. Japan, UK and Canada
5. Sweden and Switzerland
6. What Affects the Dollar Index? Let’s Sum Up

Dollar Index: What the Instrument Price Depends on

As mentioned previously, the dollar index consists of the ratio of seven currencies: the US dollar and six currencies of developed countries. What that means is that DX depends on the exchange rate of each of these currencies, but to a varying degree. This is evidenced by the percentages shown. The dollar will obviously be the key one here. Now, let’s examine the impact factors one by one.

Dollar index: chart of the trading instrument

US Dollar: Pricing Specifics

The dollar index depends on the exchange rate of the U.S. currency itself. Notably, its pricing is free and market-based and is not backed by gold. The Federal Reserve System is the central banking authority of the United States that regulates the dollar exchange rate.

The FRS maintains the level of the exchange rate which is the most suitable for the economy, using various monetary policy tools to regulate the currency’s value. The basic tool is the interest rate, which is increased during the booming economy and reduced if the risks arise.

An interest rate hike that took place during the period from 2015 to 2018 caused the increase in the dollar price. In times of crisis and turmoil, the FRS reduces the rate, thereby lowering the value of the dollar against the currency basket.

Thus, the central bank of the United States held an extraordinary meeting on March 3, 2020, having cut the interest rate by half a percentage point as the preventive measure aimed at protecting the economy from the damaging effect of coronavirus. Against this backdrop, both the dollar and DX plummeted.


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How Does the Dollar Index Depend on the Euro

The unified European currency holds the most weight in the dollar index, making up about 57.6% of the weighting. In other words, the average exchange rate of the U.S. dollar against the currency basket depends chiefly on the euro.

In addition, Euro has free market-based pricing and depends on the decisions of the regulator, namely the European Central Bank.

The economic slowdown started in the late 2018, and as of the beginning of 2020, the EU was on the verge of recession. This was caused by the China-United States trade war, since the decline in economic activity in China took a toll on Germany that has close economic ties with the Celestial Empire. The drop in the euro rate amidst the monetary easing implemented by the European Central Bank resulted in an increase in the dollar index in 2019.

In early 2020, the interest rate in the EU is at the level of 0.0%, whereas an extensive quantitative easing program aimed at boosting the economy is being implemented throughout the eurozone.

Dollar index: EUR/USD pair

Japan, UK and Canada

The weights of the Japanese yen, British pound and Canadian currency in the dollar index are slightly above 10% on average. Due to this, the economic climate of Japan, the UK and Canada has an impact on the dollar index, but to a lesser extent than the state of the eurozone economy.

The analysis of the situation in the UK, which has been trying to address the Brexit issues since 2016, suggests that the economic conditions are deteriorating. The pound is under pressure, and drop in the pound in the medium-term encourages the growth of the dollar index.

Dollar index: GBP/USD pair

As far as the Japanese yen goes, it makes sense to factor in the status of this currency. It is one of the so-called safe-haven assets the investors buy in a time of turmoil. This means that when the market is unstable and the yen is in greatest demand and going up, the dollar index is dropping.

The value of the Canadian currency depends on the monetary policy of the Bank of Canada and the crude oil prices. For that reason, the dollar index is indirectly dependent on crude oil quotes and goes up when crude oil prices drop.

Sweden and Switzerland

As we have seen, the formula of the dollar index also factors in the Swiss franc and Swedish krona. However, their total weight does not exceed 10%. So, the impact of these currencies on the DX is small.

It must be noted that the Swiss monetary policy which impacts the value of the franc has remained the same for a long time since the exchange rate intervention implemented by the Swiss National Bank in January 2015.

Dollar index: USD/CHF pair

What Affects the Dollar Index? Let’s Sum Up

So, the dollar index depends not only on the U.S. dollar itself, which maintains the status of the global reserve currency, but also on the state of the economies of other countries.

The major factor affecting the DX exchange rate is the price of the euro, which depends on the Eurozone economy. Aside from that, the dollar index depends on the situation in the United Kingdom, and indirectly on the oil prices and risk appetites.



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