The US dollarThe currency that sets the tone for all others.
The dollar is the world’s reserve currency, and most commodities are priced in it. When it moves, commodity prices, inflation and other currencies move with it, so it is the first thing to check before a trade.
The world’s reserve currency
Since the Second World War, the US dollar has been the world’s most important reserve currency. Other central banks keep large parts of their reserves in dollars, and many align their own exchange rate and interest rate decisions more or less closely with the Fed’s. More than 80% of all foreign exchange transactions involve the dollar, and each of the classic majors, EUR/USD, USD/JPY, GBP/USD and USD/CHF, has it on one side.
That is why the Fed’s decisions ripple out across the whole world. Its policy moves the dollar, and through the dollar it reaches commodity prices, currencies, bonds and stocks everywhere.
Measuring the dollar: the DXY
A single pair such as EUR/USD only tells you how the dollar is doing against one currency. To measure its overall strength and direction, traders use the US dollar index, the DXY. It compares the dollar with a basket of 6 currencies, each with a fixed weight.
The euro dominates the basket with 57.6%, more than half of the index. The yen follows with 13.6%, then the pound with 11.9%, the Canadian dollar with 9.1%, the Swedish krona with 4.2% and the Swiss franc with 3.6%. So the DXY moves much like an upside-down EUR/USD, and a big euro story alone can push the whole index.
What drives the dollar
The dollar is moved mainly by 2 things: the Fed’s policy, and how the US economy is doing compared with the economies in the basket. A strong US economy and a Fed that is raising rates attract money, because dollar assets pay more. And because it is a comparison, a weak eurozone can lift the dollar even when US numbers are only average.
The strongest moves come from divergence, when the Fed and the other central banks head in different directions. In 2016, for example, the US economy had recovered and the Fed planned to raise its key rate. The ECB had no such plans and was still buying bonds to support its economy, and Japan and the UK were also still easing. That gap in policy pushed the dollar up.
From the dollar to commodities and inflation
The dollar is also called the commodity currency, because oil, gold, silver and most other raw materials are priced in it. When the dollar rises, these goods get more expensive for buyers who pay in euros, yen or any other currency. Demand drops, and commodity prices tend to fall. When the dollar falls, commodities get cheaper for the rest of the world and their prices tend to rise.
Put a broad commodity index next to the DXY and you can see it: when the dollar climbs sharply, commodity prices slide. And because commodities feed into the price of almost everything, the dollar reaches inflation too. A rising dollar pushes commodities down and inflation tends to cool. A falling dollar lifts commodities and inflation tends to rise.
Exchange rates follow the same logic. When the dollar gains, other currencies tend to lose against it, and when it weakens, they tend to rise. That is why the dollar is the first thing to check, whatever you trade. Before a session, the DXY on the daily chart and the dollar’s place in Currency Strength tell you whether a long EUR/USD or a long gold trade goes with the current or against it.
These are tendencies. War, a supply shock or fear in the markets can override them for a while and lift oil or gold even while the dollar rises. When that happens, something else is driving the move, and it deserves a closer look.
In short
- The dollar is the world’s reserve currency and is involved in more than 80% of all currency transactions, so the Fed’s decisions ripple across every market.
- The DXY measures it against 6 currencies, with the euro at 57.6%, and divergence between the Fed and the other central banks drives its biggest moves.
- A rising dollar tends to push commodities, inflation and other currencies down, and a falling dollar does the opposite.
Questions
Why is the euro so heavy in the DXY?
Several of the original basket currencies, such as the German mark and the French franc, were replaced by the euro in 1999, and the euro took over their combined weight of 57.6%.
Key terms
- Reserve currency
- A currency that central banks and companies around the world hold in large amounts. The US dollar is the main one.
- DXY (US Dollar Index)
- An index of the dollar against six currencies, weighted mostly to the euro. A quick way to see whether the dollar is broadly strong or weak.
- Divergence (macro)
- When two economies move in different directions, for example one central bank raising rates while another cuts. Currencies often trend on divergence.
- Inflation
- The rate at which prices rise. Central banks usually aim for about 2% a year.