What is the Dollar Index & How Does it Impact - ICICI Direct

In the last one year or so, we have heard a lot of news that the US dollar is becoming stronger compared with other currencies. Last year (September 2022), the dollar reached levels not seen in the previous 20 years on the US Dollar index. But since then, the dollar index has continuously declined.

Before we look at how the rise and fall of the dollar index affect us, let us first understand the dollar index.

What is the dollar index (USDX)?

The value of the US dollar in relation to a basket of other currencies is gauged by the US dollar index. Six currencies are part of USDX - Swiss Franc, Japanese Yen, Euro, British Pound, Canadian Dollar, and Swedish Krona.

The dollar index was set up in 1973 after the Bretton Woods Agreement dissolved. The initial value of the index was 100. The Euro makes up almost 57.6% of the basket and is the biggest component, followed by the Japanese Yen with 13.6%. The pound has 11.9% weightage, the Canadian dollar 9.1%, the Swedish Krona 4.2%, and the Swiss Franc has the least weightage - 3.6%.

The strength of the US dollar against these international currencies can be tracked by looking at the value of the dollar index. If the USDX value increases, it means that the US dollar is gaining strength against all of them combined, and vice versa.

Why USDX increases?

In September 2022, the USDX index touched 114 levels, up from a low of 89 recorded in January 2021. First, let us look at when USDX increased.

The prime reason for the USDX rise last year was the US Fed increasing interest rates. When rates are increased, bond prices come down, and with the falling bond prices, the yield of these bonds goes up.

When the yield is high, there is less incentive for investors to invest in the riskier equity class, and hence stock prices fall. When the bond yield is high, demand for dollars is high, which translates into a stronger dollar. It is reflected in the dollar index - a rise in value.

Why is the dollar index falling in the last few months?

The dollar index has quickly come down in the last few months after peaking in September 2022. Below are some reasons for it:

Relief in the energy crisis in Europe.
Expectations of the US Fed going slow on interest rate hikes.
Expected political stability in the UK.

How dollar index impacts us?

The discussion, so far, suggests that the Indian rupee is not part of the index or directly related to it. Therefore, you must be wondering why the dollar index value is discussed so much. Below is the impact of the rise and fall in the value of the dollar index on India (direct and indirect):

Stock market: When the index falls, the rupee appreciates, and the dollar weakens. As a result, investors in the US see an opportunity for higher returns in India, which leads to an inflow of Foreign Institutional Investment (FII). Due to heavy inflows, there is heavy buying in the overall market, and the stock market turns bullish - goes up.
Metal price change: If we look at historical data, we can conclude that gold prices are inversely related to the dollar index value. When the dollar index increases and the dollar strengthens, the gold price will fall. Gold gets imported into India in large quantities, and therefore it impacts the economy as a whole.
Fuel prices: As we know, India is the largest crude oil importer. The change in the dollar index affects crude oil prices and impacts us. When the dollar index rises, crude oil and other commodities become more expensive. It increases our import costs and widens our current account deficit. Also, it affects the profitability of the oil importers and refineries in India.
Inflation: We have already established that an increase in the dollar index makes the dollar strong and depreciates the Indian rupee's value. A weakened rupee makes imports costlier and impacts Indian company profitability due to increased production costs. Increased costs for companies mean companies have to increase the prices of goods and services, which leads to inflation. The overall Gross Domestic Product (GDP) is impacted and suffers a slowdown when the dollar strengthens.
Companies with dollar-denominated debt: Some Indian companies have borrowed Dollar-denominated debt for cost-effectiveness. These companies are directly affected when the dollar rises. A strong dollar proves costly to companies with dollar-denominated debt as they have to shell out more in rupees to repay their debt. It impacts the company's profitability and might lead to a financial crunch.

The dollar index can help you make better investing decisions

The dollar index's movement indicates what investors can expect in the future. For example, when the dollar index value comes down, money will start flowing into asset classes from where it has come - investors may start looking at emerging market stocks and metals.

The dollar index also provides clues on whether you should invest in commodities. A weak dollar typically means strong gold and silver. Also, relatively high unemployment and high inflation make a good environment for gold prices.

Conclusion

The dollar index is a crucial indicator if you want to understand macroeconomics. It can tell you a lot about the future, and we hope to help you in predicting the future!!

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