The U.S. Dollar Index (DXY) is a vital tool for traders and investors who want to track the performance of the U.S. dollar against a basket of major global currencies. In this article, we’ll explore what the DXY is, what it consists of, why it moves, and how traders can use it to gauge dollar strength or analyse macroeconomic trends.
The US Dollar Index (DXY, or, informally, the "Dixie") is a fundamental benchmark in the global financial markets. If you are into prop trading, be it trading forex, commodities, or other assets, it is helpful for you to understand the DXY.
1. Background of the USD Index
The DXY was created by the U.S. Federal Reserve in 1973 following the breakdown of the Bretton Woods agreement. The index is the value of the U.S. dollar against a basket of major world currencies. It began with a base of 100, and all subsequent values are relative to this base.
It is presently managed by ICE Data Indices, a Intercontinental Exchange (ICE) subsidiary. The currencies represented in the DXY are commonly referred to as America's most important trading partners. The currencies have only changed once, in 1999 when the newly-created euro replaced several European currencies previously in the index.
2. Current day usage of the DXY
The DXY can inform traders, investors, and consumers about the relative strength of the U.S. dollar. Moreover, the index indicates how the greenback may affect prices for products and services as well as demand for imports and exports. This information is important and useful for economic forecasting as it sheds light on the reasons behind the current state of the economy.
3. Composition of the DXY
The DXY is essentially a weighted average, which gauges the value of the U.S. dollar against a basket of six major currencies: the euro (EUR), Japanese yen (JPY), Canadian dollar (CAD), British pound (GBP), Swedish krona (SEK), and Swiss franc (CHF).
The weight of each currency shows the relative value of every currency in the U.S. foreign commerce. Amongst the six currencies, the euro affects the index most; hence, DXY is highly sensitive to EUR/USD fluctuations.
The weightings are currently as follows:
- Euro - 57.6% weight
- Japanese yen - 13.6%
- Pound sterling - 11.9%
- Canadian dollar - 9.1%
- Swedish krona - 4.2%
- Swiss franc - 3.6%
4. Interpreting the DXY
As the index is based on a value of 100, if it reaches 120, it indicates that the U.S. dollar has strengthened 20% versus the basket of currencies over a particular time period.
Similarly, if the index value decreases to 80, a fall of 20 from its initial value, it implies a 20% depreciation in strength relative to the other currencies.
5. Factors influencing the DXY
The DXY reacts to political and economic elements, some of them include:
- The Federal Reserve (Fed) interest rate decisions: The DXY often gains when the Fed hikes rates. When interest rates go up, foreign investors are often attracted, boosting demand for the US dollar and making it worth more than other currencies.
- The U.S. economic indicators: These indicators may include GDP growth, employment statistics and inflation (typically measured by the Consumer Price Index). If the economy is doing well, the dollar may strengthen, but if the economy is struggling, the dollar might weaken. For more details, you may check out our previous article on an introduction to the U.S. dollar here.
- Market sentiment: Market sentiment refers to how confident or nervous investors feel about the markets. When the market outlook is gloomy, investors often flock to the U.S. dollar (as it is considered a safe-haven asset), driving up its value.
- The relative strengths of the other economies in the basket, especially the eurozone, due to the heavy weightage of the euro in the DXY.
6. Why does the DXY matter?
The DXY is one of the most important numbers in the world's financial markets for several reasons.
- The U.S. dollar is the world's main reserve currency, and it is used in most of all foreign exchange trades.
- The world’s primary commodities, such as oil and gold, are priced in USD. Hence, the USD index will affect the prices of these commodities. This is important for traders and prop traders who trade commodities.
- The U.S. dollar is prevalent in global trade. If the dollar gets stronger (the DXY goes up), it affects the prices of goods that are priced in dollars for people who use other currencies.
- Central banks worldwide monitor the DXY closely. When the index changes, monetary policy may need to adjust accordingly. This is especially true for developing markets that are sensitive to changes in the dollar.
7. Closing notes
Tracking dollar changes in global markets is best accomplished using the DXY. The index offers an understanding of market trends, risk attitude, and the relative value of the most traded currencies worldwide. Whether you’re an experienced prop trader or a novice prop trader, monitoring the DXY will help you make better decisions and craft better trading strategies.
Now that you’ve learned more about how the USD is valued relative to major world currencies, you may be wondering how you can monitor such changes in a practical trading set-up. This is where the Currency Strength Tool offered on the OANDA Labs website comes in handy, enabling traders to track currency strengths.
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