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Understanding the U.S Dollar Index

Historical Background

The Bretton Woods Agreement was established in 1944 to set a new monetary system and stabilize the world economy after World War II. One of the critical features of the agreement was to choose the U.S dollar as the world reserve currency; other currencies would be fixed to the dollar, and the dollar itself would be pegged to gold at a price of around 35$ per ounce.  However, in 1971, President Nixon suspended gold convertibility due to rising concerns about the relationship between the link of the exchange rates and the price of gold; henceforth the Bretton woods agreement was terminated in 1973. (Look out for an upcoming Focus Issue - Gold & the History of the International Monetary System). The suspension of the dollar-gold peg meant that the dollar would now be floating against global currencies. However, the Fed needed to provide some sort of measurable value to the dollar against other currencies, and so came the establishment of the U.S dollar index.

Description and Methodology

The USDX is a trade-weighted average measure of the value of the U.S. dollar against a basket of six other foreign currencies. The currencies and their respective weights are as follows: Euro – 57.6%, Japanese Yen – 13.6%, British Pound – 11.9%, Canadian Dollar – 9.1%, Swedish Korona – 4.2%, and the Swiss Franc – 3.6%. The USDX, like any stock index, can be traded and is traded on the intercontinental exchange or ICE in short. The base measure of the USDX is 100, so if it is trading at say 120, this indicates that the dollar has appreciated 20% in relation to the basket of the six other currencies, and the opposite is true. Therefore, as the dollar gains strength, the index goes up and vice versa. So that leaves us with a question – What affects the dollar? We will go into greater detail in next week’s Focus Series, but here are some elements to think about; capital, current and trade account dynamics – economic activity - inflation – Interest rates - macroeconomic factors – market sentiment.