The six currencies which are included in the US dollar index are America’s major trading partners. The index has been replaced only once when the Euro replaced German Mark, French Franc, Italian Lira, Dutch Guilder and the Belgian Franc.
It is calculated by factoring in the exchange rates of six foreign currencies i.e. Euro (57.6%), Japanese Yen(13.6%), Canadian Dollar(9.1%), British Pound(11.9%), Swedish Krona(4.2%) and Swiss Franc(3.6%).
The US dollar has a history of volatile movements and reached an all-time high of 165 in 1984 and made an all-time low of 70 in 2007. Overall, the index has been relatively range bound between 90 and 110.
The current movement of the dollar index started from May 02, 2021, when it made a low of 89.39 and a high of 109.44 on August 29, 2022. The dollar index after reversing from a six-week low of 104.63 rallied almost 4.60 per cent, making a high of 109.44.
Currently, the dollar index is at 108.73 with support at 107.40 and a resistance at 109.50. The breach of 107.40 will take it to 105 levels which is crucial support while a breach of 109.50 will take it higher towards the 111-112 band.
Reasons for the upside in dollar index
The dollar has been edging higher on account of aggressive US Fed rate hikes of 2.25 per cent till date. Fed officials and chairman Jerome Powell have been very hawkish on interest rates as they want to bring down inflation from 8.50 to 2 per cent.
During the Jackson Hole Meeting of Central Bankers on August 27, 2022, Powell said that the main aim of the US Fed is now to bring down inflation to 2 per cent even if that requires some sacrifice on growth.
The Fed officials saw little evidence that US inflation pressures were easing and steeled themselves to force the economy to slow down to control an ongoing surge in prices, as per the last FOMC minutes.
The US Central Bank policymakers are committed to raising the rates as high as necessary to tame inflation – even as they begin to acknowledge more explicitly the risks might be too far and may curb economic activity and the labour market too much.
The FOMC is scheduled to meet on September 20 and 21, 2022, to announce its rate decision which after the Jackson Hole meeting is expected to be raised by 75 bps.
On the contrary, despite having higher inflation, the rate hike in the Eurozone has been only 50 bps till date while in the UK it is 125 bps.
The Central Bankers of the Eurozone and UK are not hawkish enough to ensure that their currencies do not fall. Euro is at 20 year low while GBP is at two year low. Hawkish ECB expectations are underway ahead of the policy decision next week.
The Bank of Japan is still following an easy money policy with rate of interest stable at -0.10 per cent and therefore the JPY currency has fallen from around 102 to 140 levels against the dollar.
Higher US yields and aggressive offshore buys are keeping USD/JPY buoyant.
How will the dollar index move from here?
Due to the above reasons the dollar index seems to be in an uptrend and could possibly see levels of 111 to 112.
A close below 104 could see a swift further downside move towards 99 which could happen if the market starts to factor in the US recession and a current account deficit of above 5 per cent.
At present, the US labour market is very strong and with the Fed hiking rates, the downside to the dollar index is getting bought.