The U.S. dollar index measures the U.S. currency against a basket of reserve currencies.
The dollar index trades on the Intercontinental Exchange (ICE) futures market. The dollar is the world’s reserve currency, and the index measures it against the other fiat currencies that serve as reserve foreign exchange instruments. A reserve currency is liquid and reflects political and economic stability. Central banks worldwide own reserve currencies for cross-border payments and liquidity.
The dollar index tends to move higher and lower based on interest rate differentials between the U.S. foreign exchange instrument and the component index currencies. Meanwhile, the index only reflects the dollar’s status against the components, so the dollar can lose value on the world stage while the index remains stable or even appreciates.
The Invesco DB US Dollar Index Bullish Fund ETF (NYSEARCA:UUP) product moves higher and lower with the dollar index.
The dollar index has been steady
Since 2022, the dollar index’s trading range has narrowed.
As the chart highlights, the dollar index traded in a 20.15 range in 2022, a 7.77 band in 2023, and a 5.45 range from low to high so far in 2024. The index has traded around the 105 pivot point over the past months.
The bifurcation of the world’s nuclear powers has led to de-dollarization
The early 2022 handshake between Chinese leader Xi and Russian President Putin set the stage for Russia’s invasion of Ukraine, dramatically altering the geopolitical landscape. The sanctions, tariffs, and trade embargoes that followed created roadblocks to international trade. The war in the Middle East has only exacerbated worldwide tensions in 2023 and 2024.
The bifurcation of the world’s nuclear powers has caused Russia, China, and their allies to seek alternatives to the U.S. dollar to settle cross-border transactions to avoid the economic sting of sanctions. Over the past months, China and India have purchased crude oil from Saudi Arabia for payment in yuan and rupees. Meanwhile, the rising potential of a BRICS currency with some gold backing could change the international financial system, diminishing the U.S. currency’s dominant role. BRICS countries have been buying gold over the past years, increasing their reserves. Moreover, leading gold-producing countries, China and Russia, have vacuumed in domestic production, increasing holdings above official statistics levels.
The trend toward de-dollarization means the U.S. currency is losing its purchasing power. Meanwhile, a highly contentious U.S. election with a divided electorate and a staggering debt level has not helped the dollar, which derives its value from the full faith and credit of the U.S. government.
The dollar index measures the dollar against allied currencies, creating a mirage
The dollar index is a mirage, as it measures the U.S. against other allied reserve currencies. Europe, the U.K., Japan, Canada, Switzerland, and Sweden are U.S. allies, making the dollar index less representative of the overall international financial system. China is the world’s second-largest economy. Russia is a leading commodity producer. The Middle East is a leading crude oil producer, and India is the most populous country, with China a close second. Therefore, the dollar index only reflects a part of the global economy.
The index can rally even as the dollar loses its status as the world’s reserve currency
The dollar index reflects the dollar’s value in an allied geopolitical vacuum. While the dollar’s value against allied currencies will remain a function of interest rate differentials, it has lost some footing over the past years as the trend towards de-dollarization continues and picks up steam.
The dollar index can rally and simultaneously lose value in the current geopolitical environment. The BRICS countries will encourage trading partners to move away from the dollar. Worldwide central banks already own gold as an integral part of their foreign currency reserves. Fostering worldwide trade will require them to own dollars, gold, and a burgeoning BRICS currency over the coming years, further diminishing the dollar’s role. If the dollar’s role declines, its purchasing power will fall, supporting higher inflationary pressures, higher U.S. interest rates, and increasing debt levels. China has reduced its exposure to the U.S. bond market as tensions between Beijing and Washington increase.
The bottom line is the U.S. dollar index, once an indicator of the dollar’s international role, is now only a barometer of interest differentials between the U.S. and its geopolitical allies. Meanwhile, even the U.S. allies with active trading relationships with BRICS countries will need to own an emerging BRICS currency to facilitate trade, further weighing on the dollar’s international role.
UUP is the ETF that tracks the dollar index higher and lower- Interest rate differentials are critical for the index’s path of the least resistance
The dollar index has been stuck in neutral. In a sign of the dollar’s overall weakness, the ECB cut interest rates on June 6, but the dollar index fell. While the market may be assuming the Fed will follow the ECB, lower European rates should have caused a rally in the dollar index, given the 57.6% exposure to the euro currency. We could see more volatility in the dollar index over the coming months and years as the world financial system undergoes a significant change.
The most direct route for a risk position in the dollar index is the ICE futures and futures options market. The Invesco DB US Dollar Index Bullish Fund ETF tracks the price action in the dollar index. UUP’s fund profile states:
At $28.84 per share, UUP had nearly $426 million in assets under management. The current interest rate level translates to a $1.75 or 6.08% annual dividend for UUP. Seeking Alpha’s ETF grades award an A+ for the dividend. UUP trades an average of nearly 640,000 shares daily and charges a 0.75% management fee.
Interest rate differentials between the U.S. dollar and the index’s component currencies will determine the dollar index’s path of the least resistance over the coming months and years. As the trend towards de-dollarization continues, the dollar index may lose its footing on the international landscape. However, it will still be an excellent barometer of rate differentials and economic fundamentals between the U.S. currency and the other allied foreign exchange instruments.
Given the level of U.S. debt and the division in the U.S. electorate going into the November election, a Fed interest rate cut could cause the index to fall below the 100 level and test critical technical support at the July 2023 99.580 low. Below that level, the next technical supports are at the early 2021 89.20 low and the February 2018 88.25 bottom. During the 2008 global financial crisis, the dollar index fell to 70.69.
Markets reflect the economic and geopolitical landscapes. The dollar index faces many challenges in the current environment. While UUP moves higher and lower with the dollar index, the Invesco DB US Dollar Index Bearish Fund ETF (UDN) moves higher when the dollar index declines. At $18.00 per share, UDN had $55.74 million in assets under management. UDN trades an average of 26,107 shares daily and charges the same 0.75% management fee. UUP and UDN are unleveraged ETFs, so they do not suffer from time decay and are appropriate for short, medium, and longer-term risk positions.
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