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US DOLLAR INDEX

For those who have been trading stocks one may be familiar with the VIX which is a market sentiment indicator based on the balance of option buying and selling in the market. In essence it indicates the levels of fear or complacency in the market, and is used as a contrarian indicator. In other words if everyone is very relaxed and calm, the indicator is low, so it is time to do the opposite and sell, similarly when the readings are high with fear in the markets, it is time to buy. The VIX slogan is " when the VIX is low it's time to go, when the VIX is high it's time to buy". Currencies too have a market sentiment indicator and is called the US Dollar Index.

The US dollar index is one that has been around a long time. The start of the index is March 1973. This is when the world’s biggest nations met in Washington D.C. and all agreed to allow their currencies to float freely against each. The start of the index is also known as the “base period”. but is little used by retail currency traders as generally they have never heard of it. It is a futures’ index which is quoted 24 hours a day seven days a week and is on the NYBOT (New York Board of Trade), and represents the relationship between the US dollar and six major currencies.

USDX Formula calculation:
USDX = 50.14348112 × EURUSD^(-0.576) × USDJPY^(0.136) × GBPUSD^(-0.119) × USDCAD^(0.091) × USDSEK^(0.042) × USDCHF^(0.036)

USDX - Dollar Index
USDX LIVE CHART

How the US Dollar Index used in currency trading decisions?
By using a combination of candlestick technical analysis, support and resistance and moving averages, one can form a view of the US Dollar based on long term trends, possible short term and long term reversals and changes in market sentiment, against the major currencies in the basket. It is important to understand, that like it or not, the US Dollar dictates the trends in all the major currencies, and therefore this index provides an excellent starting point for determining the US Doll ar’s strength or weakness in relation to the currency pairs.

REASONS FOR A MAJOR TURN IN THE US DOLLAR

BULLISH DOLLAR
While the Dollar Index hits multi-decade lows and as the euro continues to trade within striking distance of record highs, savvy investors are beginning to wonder if the current market conditions present a unique opportunity to buy the US currency at ultra-cheap levels. However, with the Federal Reserve aggressively cutting rates and talk of an oncoming US recession dominating the airwaves, investors are understandably concerned about buying the beleaguered buck at this time Here are a few reasons why being a dollar-bull may be a good idea this year, even if the United States experiences a serious economic slowdown:

Here are a few reasons why being a dollar-bull may be a good idea this year, even if the United States experiences a serious economic slowdown:

Dollar near all-time lows:

Fed ahead of the curve everyone else is behind:

Lower US Interest Rates and a stimulus plan:

Lower dollar:

Deep US recession:

Bargain opportunity?

Will the dollar outperform?

US economic rebound and a resurgence of the dollar?

Better US corporate profits, improvement in the trade deficit?

Dollar becomes a safe-haven play?

THE FEDERAL RESERVE IS AHEAD OF THE CURVE

- Fed lowers the cost of capital by 40% in just 6 months
- Makes adjustable rate mortgages more affordable

When it comes to the US economy what is the elephant in the room? Clearly it is housing. Would the Federal Reserve have cut rates by a whopping 125bp in just one month if the housing sector was not in such terrible trouble?

Dollar Index Through 1998-2008US Dollar

When the subprime crisis became front-page news in August 2007, the Federal Reserve responded quickly to the growing problems in the credit markets. It dropped the discount rate by 50bp to 5.75% and provided liquidity to the banks through its open market operations. Other central banks followed a similar path, but the Fed was the first major central bank to take the easing process a step further by lowering the Fed funds rate a full 50bp in September. Then, while other central banks debated the merits of lowering rates or staying put, the Fed did not hesitate and continued to ease aggressively by cutting rates another 50bp in December and then a whopping 75bp in January. Altogether, the Fed reduced rates by 175bp in just six months and dropped the Fed Funds rate from 5% to 3%, providing a near 40% reduction in the cost of short-term capital for the US banking system.

WHILE EVERYONE ELSE IS BEHIND IT

- ECB stubbornness could lead to a severe contraction in Europe later in the year
- BOE already forced to lower rates
- As easing accelerates, European currencies lose their principal advantage of higher interest rates

In contrast to the Fed, other central banks have been very slow to act; EU and UK monetary officials proved to be much less responsive to the crisis. The Bank of England stubbornly refused to boost liquidity; consequently, within a few months, Sterling Libor rates (the rates which banks charge each other for overnight loans) spiked higher amidst the rapidly tightening credit conditions, forcing the Monetary Policy Committee to begrudgingly reduce interest rates by 25bp in December and by another 25bp in February 2008. In the meantime, while the European Central Bank did move quickly to add liquidity to the system by temporarily loaning funds to banks, they left the rates unchanged at 4.00%, providing no help to businesses.

Meanwhile, reports in both the areas have started to signal a significant deterioration of economic conditions. With global growth anticipated to slow further this year, these cracks could turn into canyons, which may force the Bank of England and European Central Bank to make up for lost time and slash rates much more aggressively in the second half of 2008. Should that be the case, both currencies would lose their attractiveness as their yields quickly decline. Meanwhile, the dollar should rally as speculators and investors dump euros and pounds. In short, while most of the bad news is already priced into the dollar, the markets may be underestimating the potential risks to other advanced economies. Currencies are always a relative bet, and the dollar can appreciate, even in a challenging economic environment if its trading partners are faring worse.

LOWER US INTEREST RATES + STIMULUS PLAN = US ECONOMIC REBOUND?

- Fed easing stabilizes the housing market
- US consumer boosted by stimulus package
- US economy merely slows, does not contract
- No need for additional rate cuts

Whether you want to call it a "panic response" or an aggressive attempt to lessen the blow of an oncoming recession, the Federal Reserve's rapid rate cuts should provide some soothing relief for the US economy. First, while the massive correction in the housing market is not over yet, mortgage holders may get some respite from their mortgages as interest rates ease and the government, in conjunction with mortgage lenders, offers 30-day freezes on foreclosures, allowing borrowers to modify their loans in order to make them affordable. If the Federal Reserve and the US government can curtail the growing number of foreclosures, it could help stabilize the housing sector and remove one of the biggest headwinds to US economic growth.

Meanwhile, an economic stimulus plan will start to pay out as early as May, with many taxpayers receiving a rebate of between $600-1200. The hope of Congress and the Bush Administration is that the money will boost consumer spending and help rejuvenate the services sector. The plan also includes adjustments that will allow small businesses to expense, rather than depreciate certain asset purchases. As a result, businesses will be more likely to keep their workers, exerting less pressure on the unemployment rolls.

While these policy initiatives won't necessarily work wonders overnight, they may greatly reduce the risk of a full-blown US recession. With markets already pricing in a doomsday scenario for the US economy, any evidence of growth—even if it's relatively modest—will be viewed positively by the currency market and could lead the dollar to rebound while investor sentiment improves.

BIG BUSINESSES BENEFIT FROM A WEAK US DOLLAR MAY ACTUALLY BE A BOOST

- US multi-nationals benefit from lower dollar, profits surprise to the upside
- US stock markets bounce as a result attracting foreign investment and demand for the dollar
- US trade balance improves as exports boom, contributing to growth

The tax code changes included in the US government's economic stimulus plan are geared towards consumers and small businesses, but what about large multi-national corporations that bring in millions of dollars in profits and hire thousands of workers each year? These firms are already getting some help in the form of the weak US dollar.

The decline in the currency has turned US-made goods into relatively cheap products compared to those from the euro zone or UK. For example, the US-based aircraft giant, Boeing, beat out Europe's Airbus in orders during 2007. If the market for aircraft isn't as fertile as it was in 2007, these companies will likely be forced to be even more competitive in 2008, and the low exchange values could provide US corporations with a crucial edge in winning more business. This dynamic is not only good for the domestic economy, but it is also positive for the US trade deficit and stock market. If investors from abroad decide to buy up stock in US corporations, the influx of capital into the U.S. will actually end up helping the greenback structurally as the US trade deficit contracts and US investment flows expand.

US Trade Balance 2002-2008US Trade Balance from 2002-2008

COULD RECESSION BE A BOOM FOR THE BUCK?

- Paradoxically, worst-case scenario for the US economy could be positive for the dollar
- Global economic slowdown will lead to liquidation of risky assets
- Demand for US treasury bills and bonds will soar
- Dollar will benefit as safe-haven repository

As we mentioned above, capital flows into US assets can provide a boost to the dollar from a supply / demand point of view, but the greenback can gain even under the worst-case scenario of a severe US economic recession. Presently, global central banks are worried about the stability of the financial markets, leaving investors concerned as well, which is why we've seen waves of risk aversion sweep through the financial markets. If conditions become worse—be it from a major corporate or government default, or some sort of systematic failure—there is little doubt that global financial markets will become panicked and turn volatile once again. Subsequently, investors will flee to safe haven assets, and US Treasuries tend to benefit greatly during such times. If the shift in funds is large enough, the surge in demand may quickly boost the value of Treasuries, and therefore US dollars as investors flock to safety. Paradoxically enough, in times of trouble, the dollar is likely to stand as the currency of last resort and therefore, even if you are not bullish on the prospects of the U.S. or global economy, you may still want to be long dollars.

BEARISH DOLLAR
With the Dollar Index hovering near all-time lows, some analysts see bargain. However, buying dollars may be as tough as catching a falling knife. None of the factors that have been responsible for the decline of the greenback disappeared. In fact, if anything, the situation has only become worse.

Here are a few reasons, despite the steep decline, why being a dollar bear may still be a good idea in 2008

US slowdown turns into a severe recession:

Low rates make lead to USD carry trade:

Low dollar leads to less foreign investment:

Gulf states de-peg from the dollar:

10m households foreclosed, US consumer devastated

Will the Dollar be the new Yen?

How does the US finance the deficit?

Dollar losses it reserve status dominance

US SLOWDOWN TURNS INTO A RECESSION

- 10M households in foreclosure
- Massive decline in consumer demand

When it comes to the US economy, what is the elephant in the room? Clearly, it is housing. Would the Federal Reserve have cut rates by a whopping 125bp in just one month if the housing sector were not in such terrible trouble?

Absolutely not, While the direct impact of housing accounts for only 5% of GDP, analysts estimate that since 2002, housing’s indirect influence on the US economy, via the finance and retail sectors, could be as much as 40%. Little wonder then that the greatest fear facing US policy makers is the possibility of 10 million households facing foreclosure in the next 24 months. The situation appears so dire because of a deadly combination of rapidly declining housing prices in conjunction with a massive wave of resets of Adjustable Rate Mortgages.
Dollar Index Through 1998-2008US Dollar

As poorly capitalized home owners are faced with the prospect of markedly higher monthly mortgage payments while the equity in their houses deteriorates, many find themselves “upside down” and owning more of their loans than their homes are worth. In such circumstances, some home owners have chosen to simply mail the keys to the house to their bank and default on the loan—a move derisively termed as “jingle mail.”

If the beleaguered mortgage payers decide to default en masse, the repercussions for the US economy would be disastrous; the result of which is the possibility of many key players in the financial sector being forced into bankruptcy. FDIC insurance notwithstanding, the ripple effects could endanger assets of fiscally healthy consumers as well, and the concomitant contraction in demand would bring economic activity to a halt. With consumption making up more than 70% of the US economy, a sudden and sharp decline in net worth would push the US economy from slowdown into a full blow recession, necessitating further rate cuts from the Fed.

THE US DOLLAR BECOMES THE NEW JAPANESE YEN

- Dollar interest rates decline to 1% or less
- Europe, Australia, New Zealand, and the UK maintain or increase their interest rates
- Dollar comes under constant pressure from carry trade flows

Anyone that is familiar with the forex markets knows about the "carry trade"—the method by which traders buy high-yielding currencies, like the New Zealand dollar, and fund the trade in currencies with low interest rates, like the Japanese yen, in order to reap the greatest profits. While investing in carry trades is never a sure bet, (they are prone to sharp reversals during periods of turmoil in financial markets leading to potential losses), the prospect of raking in additional profits via accumulated interest always keeps risk-seekers coming back for more.

Since September of 2007, the Federal Reserve's aggressive rate cuts have dragged the overnight lending rate to a two-and-a-half year low of 3.00 percent, pushing the US dollar down towards the low-yielding ranks with the Swiss franc and Japanese yen. When - not if - the Fed enacts additional rate cuts, traders that used to be drawn to the Japanese yen as a funding currency for carry trades may now turn to the US dollar, especially as other central banks, such as the European Central Bank, remain hesitant to reduce rates given persistent price pressures stemming from oil and food costs. Inflation has also been particularly problematic in the Asia-Pacific region, as the Australian and New Zealand economies depend heavily upon commodity production. Moreover, the credit crunch that plagues the US and Europe has not been as severe in the region, and as a result, the Reserve Bank of Australia raised the cash target to an 11-year high of 7.00 percent in February. Though the Reserve Bank of New Zealand has not raised rates since July 2007, at 8.25 percent, their overnight cash rate is by far one of the highest among the developed nations.

Clearly, interest rate differentials are not in favor of the US dollar, and the lower the Federal Reserve cuts the federal funds rate, the more likely traders are to sell the US currency against higher-yielders such as the Australian dollar, New Zealand dollar, and even the euro and British pound. If the greenback draws carry traders to the degree that the Japanese yen currently does, the constant selling pressure on the US dollar as the result of the carry flows will be a persistent weight on the value of the dollar.

HOW DOES THE US FINANCE ITS DEFICIT?

- Until recently, deficits didn’t matter
- Foreigners may pare their investments in the US
- Fed may be caught between a rock and a hard place
- Start of a vicious cycle

The US current-account deficit has reached nearly $1 trillion per year. Typically, such staggeringly large financial obligations weigh on the country’s currency, but over the past several years, the current account deficit has not been a problem for the U.S. The United Sates has been able to attract at least $60-$70 billion in capital inflows every month to offset its monthly trade deficits of approximately $60 billion. Countries such as China, Japan, and the Persian Gulf nations of the Middle East have recycled their export profits back into US government bonds. This virtuous cycle was beneficial to all parties, as the financing helped to stimulate US consumer demand, which in turn has allowed those export-driven economies to sell Americans their goods.

Unfortunately, the aforementioned virtuous cycle may be ending, only to be replaced by a vicious cycle. The Fed's persistent lowering of interest rates has diminished considerably the income received by foreigners on their US investments. In China, where the economy continues to grow at double-digit rates, the PBOC now losses more than $4 billion per month between the interest it must pay locally to attract deposits and the interest it receives on the nearly US$2 trillion of reserves it holds. Foreigners do not have to sell their current US reserves in order to hurt the dollar; they merely need to stop making additional purchases of US fixed-income assets. With no further demand for US financial assets, the demand for the US dollar will wane and the greenback will continue to fall.

DOLLAR LOSSES ITS RESERVE STATUS SUPREMACY

- Euro—a viable alternative
- GCC—Dollar peg creates inflation
- Rebalancing from 70% -30% to 65% -35%

For the greater part of the 20th century, the dollar has enjoyed the enviable position of being the reserve currency for the world. That position created a natural demand for the greenback, as most key commodities from agriculture to energy to metals were denominated in dollars. At the start of the 21st century, however, the euro appeared on the scene, and because it is backed by an economy nearly as large as the US', it provided the first real alternative to the dollar.

Recent price action in the pair has prompted many nations to reconsider their attachment to the US dollar, none more so than the oil exporting nations of the Persian Gulf. The GCC nations peg their currencies to the dollar, and the greenback's recent weakness has created massive inflation in their economy. The GCC makes most of its income in dollars from the sale of oil, but purchases more than 25% of its goods and services from the euro zone region. As a result of a much higher EUR/USD, prices have skyrocketed in the region to the point that many authorities in the region have started to debate the issue of de-pegging and even pricing oil in euros. The trend in the GCC reflects a much larger, more secular phenomenon of the erosion of the dollar's influence in global trade and finance. Presently, most central banks hold a 70% USD to 30% EUR mix in their reserves. However, if the majority of the world’s central banks begin to rebalance that shift even by a relatively small percentage of 65% to 35%, such a move would unleash massive selling flows on the currency market and drive the dollar to even newer lows.

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