Why is the US Dollar Index Rallying So Sharply?

Oct 13, 2008: 11:33 AM CST

A popular question I’ve been asked recently is “With the US Government ‘printing money’ and the Economy going into recession, why in the world is the US Dollar Index rising?!?”  Let’s take a look at a possible prevailing reason.

While clearly, there are dozens of fundamental and economic reasons as to the development, I wanted to focus on one of those major reasons:  It’s because foreign currencies are falling faster/harder than the US Dollar due to fears their economies will suffer worse than the US Economy.

Think in terms of relative strength.  Currency indexes are baskets of currency crosses, or how a particular currency is performing relative to other currencies.  It’s just like if you perform relative strength analysis on a stock to an index.  For example, if you want to know if Microsoft is doing better or worse than the S&P 500 over time, you would divide MSFT by the S&P 500 (in StockCharts.com, this is done by typing MSFT:$SPX into a chart).  You are then given a ratio which either rises or falls as MSFT outperforms (rising line) or underperforms (falling line) the S&P 500.

There’s a particularly strange phenomenon that develops when both are declining in price, but MSFT is declining at a lesser pace than the S&P 500, in which the relative strength line will be rising while Microsoft is falling.  It can be a puzzling scenario, especially when you see MSFT has a rising relative strength line and you invest in it, only to lose money and get confused.  In reality, MSFT declined less than the S&P 500, but it still declined.

This occurrence likely a major reason in the US Dollar Index rise relative to other countries’ currencies.  Remember, the US Dollar Index is structured as the following:

The Euro (57%), Japanese Yen (13%), British Pound (12%), Canadian Dollar (9%), Swedish Krona (4%), and Swiss Franc (4%).

For a full definition of the US Dollar Index and its calculations, see the Wikipedia Article or the explanation from Akmos Trade.

That being said, let’s view a comparison at some of these currencies, and then look specifically at the Australian Dollar, which has declined precipitously recently:

Remember that the Euro currency makes up roughly half the ‘value’ of the US Dollar Index, and it fell sharply from the mid-July peak (along with other currencies) to the current lows on the year.  The Canadian Dollar also suffered sharply during this time, along with the British Pound.

The Japanese Yen (not shown in the comparison) actually has shown relative strength as well against other currencies, and it almost mirrors the US Dollar Index recently (though again, a recent phenomena – not a salient one).  While the Yen is rising against other currencies, the Yen makes up only 13% of the US Dollar Index, thus the impact is mitigated, and clearly offset by the majority of currencies falling relative to the US Dollar.

Look at some of these currency index charts on your own for more insights.

Although the Australian Dollar does not comprise the US Dollar Index, it represents a ‘poster-child’ of the commodity collapse (along with Canada) and its currency – and economy – has suffered in kind:

This is a weekly chart, which captures the rising trend which coincided along with the commodity rally, both of which turned sharply downward in mid-July 2008.  The Aussie Dollar paid the severe price.

So, perhaps it’s not necessarily that the US Dollar Index is the ‘greatest thing since sliced bread’ or that the value is rising because of the hopes and dreams of investors.  It’s more likely that the Credit Crisis has spread and investors are expecting foreign economies will suffer worse relative to the United States in this global economic ‘recession,’ and that commodities – which often trade ‘inverse’ the US Dollar Index – have fallen under the same hypothesis of global ‘demand destruction.’

This is just one of the many phenomena at play – continue to watch the US Dollar Index and other currency pairs for deeper insights going forward.

2 Comments

2 Responses to “Why is the US Dollar Index Rallying So Sharply?”

  1. Bill Luby Says:

    Another excellent post, Corey. You nailed this one…and in perfect laymen’s terms, to boot.

    Cheers,

    -Bill

  2. Corey Rosenbloom Says:

    Thanks Bill! Always great to hear from you!