InvestorQ : What exactly is the dollar index and what does the dollar index indicate for you as an investor?
Neelam Naik made post

What exactly is the dollar index and what does the dollar index indicate for you as an investor?

Priyanka N answered.
3 years ago

The dollar index (DXY) is a Bloomberg formulated index of the dollar as a currency with reference to a basket of hard currencies. The DXY measures the strength of the dollar versus this basket of hard currencies and makes a statement on whether is strong or weak. The dollar index has gone as low as 80 in the last few years and has gone as high as 108 in the recent past. More than the absolute value of the DXY it is the trend of the DXY that really matters from an analytical perspective. A rising dollar index shows the dollar strengthening while a falling dollar index shows a weakening dollar. Since most countries (including India) have most of their trades denominated in US dollars, this is the best proxy for the weakness or strength of the rupee.

The dollar index has had some clear triggers in the last few years. For example, from the time Trump got elected to the US presidency, the DXY has been steadily rising over the last few weeks and the rise has became much sharper after Trump won the US presidential elections. That is hardly surprising. Trump had promised to drastically cut corporate and individual taxes and has also committed to spend $1 trillion on infrastructure. This is likely to unleash a virtuous consumption cycle in the US which may set the base for a rate hike. It is in response to a likely rate hike that the dollar has been strengthening. (Dollar index measures the value of the dollar versus a basket of global currencies. Also the dollar strengthens or weakens based on whether the Fed trajectory on rates is hawkish or dovish.

From the perspective of countries like India, the key question is what does a strengthening DXY mean for emerging markets in general and India in particular. There are 4 things to note…

Keep an eye on monetary divergence

Monetary divergence typically happens when one major economy is following a hawkish central bank policy while another major economy is following a dovish monetary policy. That is happening today with the US being hawkish while EU and Japan are still dovish. For the Indian economy this has 2 key implications. Firstly, monetary divergence results in a sharp increase in volatility across emerging markets. That is already visible in the India VIX. While the US CBOE VIX is trending down, the India VIX has been trending up. This is true of most emerging markets. Secondly, for sectors like IT and pharma which export to both the US and the EU region, this monetary divergence creates cross-currency headwinds. In the past, Indian IT companies have taken a hit of 0.5-0.7% on their profits due to these cross currency headwinds.

Strong DXY means that the capital flows could turn tide against the EMs

This is a trend that is already visible in global markets today. India has seen FII selling of nearly $5 billion in the last 1 month across equity and debt combined. The answer is the compression of spreads. When India’s 10-year bond yields were around 7.80% in early 2015, US 10-year bond yields were at 1.80%. Today India’s bond yields are at 6.30%, while the US bond yields are at around 2.30%. Effectively, over the last 2 years, the spread between India’s benchmark 10-year yield and the US benchmark 10-year yield has fallen from 600 basis points to 400 basis points. If the US continues its hawkish policy and India its dovish policy, it may compress the spread even further and may provide a good opportunity for FIIs to sell out of EMs like India and re-allocate their money to risk-off havens like US bonds

More than the DXY, countries like India should watch out for the Yuan movement

Even as the US Dollar index continues to appreciate, what many analysts have ignored is the impact on the Yuan and the concomitant impact on other emerging markets. The Yuan has been consistently weakening against the USD, a strategy that has suited China considering it’s predominantly export focus. A weakening Yuan has larger implications for other emerging markets as was very evident in August 2015. We need to remember that China accounts for over 50% of the commodity imports across the world. Therefore most of the commodity driven EMs are largely dependent on Chinese demand. Be it ore, oil, zinc or copper, China continues to be the world’s largest consumer. A weakening of the Yuan will mean other EMs too will be forced to devalue their currencies to stay competitive. This could result in a mini-currency war among EM nations. There is also the risk that a weak Yuan will result in China dumping its products at cheaper rates into emerging markets.

The DXY movement will have its impact on importers and exporters in a big way

For an economy like India, which still relies on imports for 80% of its oil requirement, a strong dollar is not great news. India is already running a monthly trade deficit of $10 billion and that could worsen if the dollar strengthens further. A stronger dollar will mean that India will end up importing inflation from other countries and the CPI may actually go back to higher levels. There is also a worry on the foreign currency borrowings front. Indian companies have billions of dollars raised through ECBs and FCCBs, most of which is not entirely hedged. A sharp rally in the DXY not only adds to the risk of repayment but also makes hedges more expensive. Globally, the total dollar debt outstanding to non-banks is to the tune of over $9 trillion. That could also get severely impacted by a strengthening DXY.

The dollar index (DXY) has normally remained in an uptrend if the hawkish stance of the Fed continues. Currently, the Fed has ruled out any rate hikes during the year 2019 and has almost adopted a dovish stance. For India, it may add a new dimension to foreign flows. For the last couple of years, FIIs found the Indian markets attractive as the INR was either stable or gradually calibrated downward. However, we saw a sharp selloff in Indian equity and debt in 2018 leading to record outflows of Rs.85,000 crore during the year. The sharp rise in the DXY during the previous year took the INR closer to the 75/$ mark. Of course, the dollar has since tempered and the rupee has come back closer to the 70/$ mark. But movements in the DXY or the dollar index remain a key determinant of the likely movements in the rupee and in equity and bond values in India.