The dollar index and the market seem to be playing a joke -
On July 13, the US index fell below the 100 integer mark due to the unexpected recovery of the US CPI data, and just when the market was betting that the Fed's interest rate hike cycle would end and shorted the US dollar, the US dollar index got out of the decline and rebounded from 99.5 all the way to the 103 line.
Recently, driven by resilient economic data in the United States and hawkish rhetoric in the minutes of the Fed's July monetary policy meeting, the market's anxiety about US inflation seems to be rekindled. On the other hand, as the U.S. government issued more Treasury bonds in response to the growing deficit, the U.S. bond and dollar markets were back in turmoil. As of August 17, the 10-year Treasury yield rushed 4.3%, hitting a new high since October 2022, and the 2-year Treasury yield exceeded 5%.
Generally speaking, inflation often means that the purchasing power of the currency is reduced, the currency is depreciated, and the upward inflation should be negative for the dollar, and the downside should be positive for the dollar. In other words, as a representative index of the US dollar, the US dollar index should simply change in the opposite direction of inflation. However, looking at the long-term data, it can be seen that the two trends are not always strictly inversely correlated (Figure 1-a), and the two have even shown nearly the same trend in the past two years (Figure 1-b).
Why is the dollar index moving in the same direction as inflation this time? What are the mysteries behind the recent volatility of the US dollar index? This issue of the Financial Encyclopedia will discuss the above issues with you.
Figure 1 Trend of US dollar index and US inflation rate (a) (1973-2020)
Image source: FRED
（b）（2018.5-2023.7）
Image source: Sina Finance, self-made by the author
Dollar Index – an "incomplete representation" of the US dollar
Let's start with the dollar index. The dollar index (USDX) is an indicator that comprehensively reflects the exchange rate changes of the US dollar in the international foreign exchange market, which measures the degree of exchange rate change of the US dollar against a basket of currencies by calculating the comprehensive rate of change of the US dollar against a selected basket of currencies, so as to measure the strength of the US dollar, thereby indirectly reflecting the changes in the export competitiveness and import costs of the United States.
After the collapse of the Bretton Woods system in 1973, the dollar decoupled from gold, leading to currency market volatility. At this time, in order to measure the performance of the US dollar relative to other currencies, the New York Cotton Exchange (NYCE) created the US dollar index.
Note: In 1998, the New York Cotton Exchange and the Coffee Sugar Cocoa Exchange merged to form The New York Board of Trade (NYBOT). In September 2006, the New York Futures Exchange merged into the Intercontinental Exchange (ICE) as a division. The current dollar index is released by the Intercontinental Exchange (ICE), also known as the "ICE Dollar Index".
It is calculated by reference to the geometric mean weighted value of the changes in the exchange rate of 10 currencies against the United States dollar in March 1973, and its value is measured against a benchmark of 100.00. After the birth of the euro on January 1, 1999, the number of currencies in the basket was reduced from 10 to 6, namely the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc, with weights of 57.6%, 13.6%, 11.9%, 9.1%, 4.2% and 3.6% respectively
In general, there are roughly four factors that affect the US dollar index:
The first is the health of the US economy. If the US economic data is good, the US shows a strong economic recovery, which will stimulate the appreciation of the US dollar, and the dollar index will rise.
The second is the level of US dollar interest rates. If the U.S. raises the federal funds rate, it means that dollar investors can get higher yields, which stimulates investors to buy dollars, and the dollar index rises.
The third is risk aversion. The US dollar is the world's main reserve currency and is at the heart of the international monetary system. When there is a global crisis, the dollar is often sought after, which stimulates the dollar index to rise, which reflects the safe-haven nature of the dollar. For example, the dollar index strengthened after the financial crisis in 2008 and after the outbreak of the new crown epidemic in Europe and the United States in March 2020.
Fourth, the relative interest rate differential of other countries. From the composition of the dollar index, it can be seen that the dollar index is a weighted average of the exchange rates relative to the other six currencies, and changes in the bilateral exchange rates of these currencies and the US dollar will affect the US dollar index. Among them, the euro accounts for nearly 60%, so the fluctuation of the euro has a great impact on the strength of the dollar index.
It can be seen that although the dollar index can be used as an indicator to observe the strength of the dollar, its volatility is not only related to economic and political events in the United States, but also affected by other factors that are not its own. Under the complex intertwining of various factors, the movement of the dollar index does not fully reflect the strength of the dollar. It can be said that the dollar index is only an "incomplete representative" of the dollar, and its rise and fall changes cannot be completely equated with changes in the strength of the dollar.
Wang Jinbin, a professor at the School of Economics of Chinese Minmin University, believes that the dollar index reflects the political economy of the international monetary system's interest pattern, and the dollar strength expressed by the dollar index depends not only on the Fed's policy and changes in US economic fundamentals, but also on changes in the policy and economic fundamentals of important economies in the dollar index.
There are three reasons why the dollar index changes in the same direction as inflation
As can be seen from Figure 1-b, since the outbreak of the epidemic, inflation has shown a similar trend to the US dollar index, but the US dollar index has lagged slightly. The monthly change in CPI represented by the blue line remained between 1.0% and 1.4% in the second half of 2020 after hitting a low of 0.1% in May 2020, and officially started the year 2021 all the way higher until it reached a four-decade peak of 9.1% in June 2022. In contrast, the dollar index also started an uptrend after bottoming out at 89.2 in January 2021 and reached a 20-year high of 114 in September 2022.
The two show a near-synchronous trend, with three main factors.
First, and most importantly, one reason is that "rate hike expectations" are at work. Since 2021, inflation in major developed economies in the world has risen rapidly, with the United States being the most. The Fed, on the other hand, mistakenly believed that inflation was "transitory" and did not start raising interest rates until March 2022. Because the Fed missed the "first opportunity", the Fed only let go and accelerated the pace of interest rate hikes after raising interest rates by 25 basis points for the first time. Since domestic inflation was still rising rapidly at that time, the market expected that as US inflation rose, the Fed would take aggressive interest rate hikes, and interest rate hikes corresponded to higher US interest rates, so the dollar index continued to rise under the expectation of interest rate hikes.
Conversely, when the expectation of a rate hike weakens, it will inevitably cause the dollar index to fall. One of the major stimuli for the dollar index to fall below the 100 integer mark was the unexpected recovery of the US CPI data for June 2023, which made the market bet that the Fed's interest rate hike was nearing its end.
In general, the Fed's rate hike or cut cycle basically corresponds to the upward or downward cycle of the dollar index. However, this is not inevitable, and there have been cases of the dollar index falling during the Fed's rate hike cycle in history. For example, in 1971-1973, the federal funds rate rose from 3.71% to 10.78%, but the dollar index fell by 21% during the same period; In 2004-2007, the federal funds rate rose from 1% to 6.26%, but the dollar index fell from 87 to 80. It can be seen that the interest rate hike cycle does not necessarily mean the strong cycle of the dollar, and the interest rate hike cycle itself does not determine the dollar strength cycle.
Second, the monetary policy of other countries is not synchronized with the United States, especially the euro area, where the impact of monetary policy is more important because the euro accounts for a large proportion of the US dollar index.
At the beginning of 2022, the eurozone economy began to recover, but the euro still weakened, mainly because its monetary policy tightening was significantly slower and slower than the Fed's. On July 21, 2022, the European Central Bank announced that it would raise the main refinancing rate, marginal lending rate and deposit facility rate to 0.50%, 0.75% and 0.00% respectively, thus starting its first interest rate hike since 2011. But by then, the Fed had already raised interest rates four times, accumulating 225 basis points (see Table 1). Since the euro area does not raise interest rates as much as the United States, interest rate differentials lead to the flow of funds from the euro area into the United States, thereby stimulating the strengthening of the dollar index. In addition, due to the relative fragmentation of the eurozone financial market, the rise in European bond interest rates has a lower ceiling effect, which also leads to the weakening of the euro and the strengthening of the dollar, thereby stimulating the rise of the dollar index.
Table 1 List of interest rate hikes in the United States and Europe (2022.3-present)
In the same period when the dollar index fell below 100, US interest rates and 10-year US Treasury rates were high, which shows that the dollar is not as "bad" as it seems. One explanation is that the euro is currently "stronger".
In general, raising interest rates is the first option to fight inflation, but there is another way to fight inflation by making the currency appreciate and making imports cheaper through appreciation. Some people have pointed out that inflation in the euro area is serious, but the traditional "interest rate hike" response is not strong enough, so the European Central Bank chooses to alleviate inflation worries through the appreciation of the euro.
Since June 2022, the euro has appreciated by more than 20% against the yuan. You know, China is a global manufacturing plant, which country's currency appreciates against the renminbi, which country can fight inflation to a certain extent. Therefore, the appreciation of the euro is "remarkable", and the euro accounts for about 60% of the weight in the composition of the dollar index, which has a great impact on the dollar index.
The strengthening of the euro objectively caused the rapid decline of the dollar index in this round. However, considering the dollar index in this factor alone, the US index has little room to fall, and many analysts believe that the euro is overbought.
Third, the safe-haven nature of the dollar comes into play again. Since the beginning of 2022, the escalating geopolitical conflict between Russia and Ukraine has prompted investors to turn to safer assets, which has also pushed the dollar index to its highest level since the coronavirus pandemic caused market volatility. According to the Wall Street Journal at the time (March 7, 2022), "Over the past week, the dollar index has soared to 98.92, the highest level since May 2020, and the index has risen 2.1% last week, the highest weekly gain in the past five years." "However, geopolitical risk factors or short-term events, as risks subside in the future, the driving force caused by risk aversion factors will also fade over time."
US index and inflation, what is the future trend?
The first thing to look at is the change in inflation. While the 3% CPI data for June and 3.2% for July have eased the market, it is too early to bet on the end of the Fed's rate hike. On August 16, local time, the Federal Reserve released the minutes of the July monetary policy meeting, showing that most Fed officials believe that inflation still has upside risks and will continue to have a negative impact on the US economy, and further interest rate hikes may be required in the future.
Fed officials are also divided within themselves. Philadelphia Fed President Harker, who has the voting rights at this year's FOMC meeting, said that as long as the recent economic data continues to remain stable, the Fed may be at a point where it can stop raising interest rates, but interest rates need to remain at a high level for a while. Fed Governor Bowman, who has permanent voting rights at FOMC meetings, reiterated that the Fed needs to continue to raise interest rates and fully restore price stability. Bowman believes that inflation is still too high, employment is too hot, and the Fed is expected to need further interest rate hikes to bring inflation back to normal levels.
On the other hand, recent inflation data may not be as "good" as the market thinks.
The first is that there is a certain fundamental effect. As we all know, June 2022 is the peak of US CPI data for more than 40 years, and the high base effect cannot be ignored. CICC Research Xiao Jiewen and Zhang Wenlang believe that "as the base effect weakens in the second half of the year, the year-on-year growth rate of total CPI may bottom out."
Second, observing the core CPI, we can see that the US core CPI is still sticky. The weaker performance of the core CPI in June was affected by disturbances in some high-volatility items, such as hotels and air tickets. Since July, both new nonfarm payrolls, the unemployment rate, wage growth, and job openings data have pointed to a healthier labor market and solid wage income. At present, core inflation in the United States remains stubborn, and the crux of the problem is in the service sector, which is closely related to the labor market and wages.
At the same time, the University of Michigan consumer confidence index in June and July rebounded sharply for two consecutive months, which American strategist Alyce Anders believes will entrench high inflation. At the household level, this can affect savings, investment decisions, and wage and price-setting behavior, making it harder for the Fed to reduce inflation. A number of research institutions also believe that the tough battle between the Fed and inflation is not over.
However, the economic situation is constantly changing. The U.S. job vacancies and voluntary turnover rate released on August 1 hit a new low in more than two years; Data released by the US Department of Labor on August 4 showed that the number of new jobs in the non-agricultural sector in July was 187,000, which was lower than market expectations. Multiple indications suggest that the Fed may be less worried about the emergence of a "wage-inflation spiral." More weaker labor force data in the future could further support this conclusion. Moreover, the recent continuous rise in international oil prices has also brought hidden concerns to inflation. This can only be left to time and data.
Looking at the dollar index, the factors are more complex. Taking Fitch's cancellation of the highest credit rating in the United States on August 1 as an example, the US dollar index fell slightly as soon as the news came out; But if Fitch's decision stimulates safe-haven demand, it may increase dollar demand, making the dollar's weakness not sustainable.
For the dollar index, the US economic outlook and monetary policy are the most important factors affecting the dollar index, but the dollar is the dollar of the world, and any wind and grass in the global political economy may affect its trend. The dollar index is another index weighted by six currencies, so it is also affected by changes in the value of other currencies.
The logic of the recent strengthening of the dollar index is that the resilience of the US economic recovery has broken expectations of a sharp interest rate hike to cause a recession in the United States, and the hawkish signals from Fed officials have led some institutions to bet that the Fed may still raise interest rates in the future.
Both inflation and the US index have reached a relatively tangled point. █
Resources:
1. On the strong US dollar under high inflation, China Macroeconomic Forum (CMF) public account of Chinese Minmin University, 2022.5.6
2. Influencing factors of US dollar price, Fun Data Public Number, 2023.1.16
3. Misled?! Does a rate hike have much to do with a strong dollar? NetEase, 2023.4.25
4. The "butterfly effect" of a strong dollar, 21st Century Business Herald, August 18, 2023