The Dollar Index Stalled but Remains at a Multi-Decade High
The dollar and the euro have been the world’s leading reserve currencies over the past years. The dollar index has a 57.6% exposure to the euro currency, making it highly sensitive to price movement in the European foreign exchange instrument. While interest rate differentials are critical for the path of least resistance of one currency versus another, geopolitics can move exchange rates. Meanwhile, the dollar index only measures the US fiat currency against other fiats. A rising dollar index may tell us the dollar is strong against its competitive currencies, but it does not indicate if all currency values, including the US dollar, are declining.
The Invesco DB Dollar Index Bullish Fund (UUP) and its bearish counterpart (UDN) reflect price changes in the dollar index on the up and downsides.
A two-decade high in the dollar index
A bullish run in the dollar index began in early 2021 when the index reached a bottom of 89.165 on the nearby futures contract.
The chart highlights the ascent of the dollar index that took it to a high of 109.140 in July 2022.
The long-term chart shows the index rose to the highest level since 2002, a two-decade high.
A retreat and consolidation periods
Bull markets rarely move in straight lines, and foreign currency markets are no exception. The world’s reserve currencies tend to experience slow and steady moves as governments intervene in the markets to provide stability. Since reserve foreign exchange instruments are critical for cross-border payments, stability is a crucial factor. Since reaching the highest level in twenty years, the dollar index corrected after moving to the high on July 14.
The short-term chart illustrates the pattern of lower highs and lower lows over the past month, taking the index to a low of 104.515 on August 10. At just below the 107 level on August 18, the dollar index has recovered from the recent low. The short-term trend remains bearish but it is attempting to turn higher, and the medium and long-term path of least resistance remains higher in the dollar index.
US interest rates are rising
After lifting off from a zero percent Fed Funds rate, the US central bank increased the short-term rate by 75 basis points in June and July, pushing it to a 2.25%-2.50% range. The rise in the US consumer and producer price indices to the highest levels in over four decades caused the central bank to address rising inflation with a tighter and more hawkish monetary policy. Aside from increasing the short-term rate, the Fed has also instituted a quantitative tightening program to reduce its swollen balance sheet. The tightening allows debt securities to roll off the Fed’s balance sheet at maturity, putting upward pressure on interest rates further out along the yield curve.
As of August 18, many market participants expect the Fed to increase the short-term rate by another 50 basis points at the September FOMC meeting, pushing the Fed Funds Rate to 2.75%-3.00%. However, some market participants believe the central bank could opt for another 75-point increase to show its commitment to battling inflation.
Meanwhile, declines in US GDP over the first two quarters of 2022 are a sign that the economy has slipped into a recession. Rate hikes will only increase downward pressure on economic conditions, which could cause the central bank to limit future rate hikes.
The most significant factor for the path of least resistance of the dollar index is interest rate differentials between the dollar and the euro currency, which accounts for 57.6% of the index’s composition. Therefore, US monetary policy over the coming months will determine if the bullish trend in the dollar index continues.
The geopolitical landscape suggests the dollar has lost some of its position
The dollar has been the dominant world currency for decades. However, the 2022 “no-limits” alliance between China and Russia, Russia’s invasion of Ukraine, and China’s plans to reunify with Taiwan have created a bifurcation between the world’s nuclear powers. With the US/Europe and its allies on one side and China/Russia and its allies on the other, the tension on the geopolitical landscape is at the highest level since World War II. The political divide suggests that the dollar’s wide acceptance is declining. While the dollar index has been moving higher, it only measures the US currency against other allied currencies, including the euro, British pound, Japanese yen, Canadian dollar, Swedish krona, and the Swiss Franc. China, Russia, and other countries doing business with them have increased their use of yuan and roubles and moved away from relying on the US dollar to avoid sanctions and establish foreign exchange alternatives. Therefore, the dollar index has become a mirage that does not reflect a worldwide currency landscape but only includes the US and its allies.
The UUP and UDN products follow the dollar index
The path of least resistance of the dollar index depends on US interest rate policy versus the euro and other index currencies. The most direct route for exposure to the dollar index is via the futures and futures options that trade on the Intercontinental Exchange (ICE).
The Invesco DB Dollar Index Bullish Fund (UUP) and its bearish counterpart (UDN) provide alternatives to the futures arena as they are products that trade on the NY Stock Exchange. UUP and UDN are liquid ETF products:
- At $28.64 per share, UUP had over $1.99 billion in assets under management. The bullish dollar index ETF trades an average of over 3.85 million shares daily and charges a 0.78% management fee.
- At $17.99, the bearish UDN product had over $74.17 million in assets. UDN trades an average of over 91,000 shares daily and charges a 0.77% management fee.
The dollar index rose from 89.165 in January 2021 to 109.140 in July 2022, a 22.4% increase.
Over the same period, the UUP ETF rose from $24.09 to $29.20 per share, or 21.2%. The difference between the futures contract and ETF is the ETF’s expense ratio over the eighteen-month period.
The index corrected from 109.14 in July to 104.515 or 4.24% in August 2022.
The bearish UDN dollar index ETF rose from $17.61 to $18.43 per share over the period, a 4.65% increase as the dollar index corrected.
While the dollar index trades around the clock, the UUP and UDN products are only available during the hours the US stock market operates.
The ETF products will not reflect any highs or lows before or after NYSE hours. The path of least resistance for the US dollar index depends on interest rate differentials over the coming months. While the short-term trend has been bearish, the medium and long-term path remains higher.
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