The US dollar and the dollar index

Why the dollar is on one side of everything 

The US dollar is the currency the greatest share of international trade is invoiced in, the currency the greatest share of cross-border debt is issued in, and the currency central banks hold the largest share of their reserves in. None of those facts is about the size of the United States economy relative to others, and all of them are self-reinforcing: an institution holds dollars because its counterparties expect to be paid in dollars, and the expectation persists because the holdings do.

The market consequence is concentration. Converting between two currencies that are not heavily dealt against each other has historically been done in two steps through the dollar, so dollar pairs accumulate turnover that has nothing to do with anyone's view on the dollar itself. This is what makes dollar pairs the deepest instruments in the currency market, and it is also what makes the dollar the single largest common factor in currency movement.

Commodities extend the same pattern into other markets. Crude oil, gold and most industrial metals are conventionally priced in dollars on international markets, so a producer or a consumer of any of them carries a dollar exposure whether or not it wanted one. The long-standing habit of pricing oil in dollars gave rise to the term petrodollar, and it is one reason commodity prices and the dollar are read together.

The problem an index solves 

A single currency pair cannot say which of its two currencies moved. When a dollar pair rises, the dollar may have been repriced, the other currency may have been repriced, or both. Since the dollar is the common leg across most of the market, the question comes up constantly, and it is what an index is built to answer: it measures one currency against several others at once, so a move that appears against all of them is a move in that currency rather than in any of its counterparts.

The most widely quoted answer is the US Dollar Index, usually written as a ticker rather than a name. It measures the dollar against a fixed basket of six currencies: the euro, the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. The basket is weighted, the weights are fixed, and the index rises when the dollar strengthens against the basket as a whole.

It is a geometrically weighted index rather than a simple average, and it was created in the early nineteen seventies, when the fixed exchange rate system that had governed the post-war period ended and currencies began to float against one another. Its base level was set at the moment of creation, and every value since is a statement about the dollar relative to that starting point rather than an amount of anything.

What the basket actually measures 

The single most important thing about the composition is how much of it is the euro. With the euro carrying more than half the basket, and the pound and the Swedish krona both being European currencies whose rates are correlated with the euro's, the index is far closer to a dollar-against-Europe measure than to a dollar-against-the-world measure. A move in the euro alone can carry the index while the dollar has done very little against the rest of its trading partners.

The second is what the basket omits. It contains no Chinese, Mexican, Korean, Indian or Brazilian currency, and no currency from any economy that has grown into a major United States trading partner since the basket was fixed. The weights reflect the trading pattern of the early nineteen seventies and have not been reset to reflect the pattern since. Whether that is a flaw or a feature is genuinely contested: an index whose composition never changes has a continuous history, and an index reweighted for current trade has a more accurate present and a broken past.

For that reason central banks and international institutions publish their own trade-weighted dollar measures, built on current trade shares and covering far more currencies, and those measures and the widely quoted index have moved apart materially over long periods. Both are correct measurements of different questions. Which one is meant is usually left implicit in commentary, which is the most common source of confusion about how strong the dollar has been over a given decade.

How the index is conventionally read 

The usual use is decomposition rather than direction. A dollar pair and the index are compared, and the comparison sorts the move into one of two cases: the pair moved and the index moved with it, which points at the dollar, or the pair moved and the index did not, which points at the other currency. This is a description of what has already happened, and it is the most defensible thing the index is used for.

What moves the dollar as a whole 

The dollar is repriced by the same channels as any currency, with one addition that belongs to it alone. United States interest rate expectations, inflation and labour market data and the yields on United States government debt all feed in through the ordinary route: they change the return available on capital held in dollars relative to elsewhere.

The addition is the dollar's role during periods of financial stress. Because so much international borrowing is denominated in dollars, a period in which institutions need to reduce risk is a period in which many of them need dollars specifically, to service or unwind those obligations. The result has been that the dollar has strengthened in several episodes whose origin was inside the United States itself, which is the opposite of what a purely economic reading would predict, and it is why the dollar is discussed both as a cyclical currency and as a haven in the same breath.

Practitioners describe this shape as the dollar smile: the dollar has tended to be strong when United States growth clearly outpaces the rest of the world, strong again when global conditions deteriorate sharply, and weakest in the middle when growth elsewhere is catching up. Like every such description it is a summary of past episodes rather than a mechanism, and the regime it belongs to is easier to name afterwards than at the time.