DXY and the Dollar Trap
In global finance, everything is relative. For now, there is no good answer to the perennial question: If not for the US dollar, then what?
That is why, despite all its flaws, the dollar remains the ultimate haven currency. And the US Dollar Index (“DXY”) measures the performance of the US Dollar against a basket of six major currencies of USA’s major trading partners.
The DXY measures USD performance against currency majors. Euro, Japanese Yen, and the British Pound represent more than 80% of aggregate weight.
Intriguingly, the absence of emerging majors such as the Chinese Yuan (CNY) and the Australian Dollar (AUD), stands out. The DXY will likely be modified in the future to reflect shifting global dynamics.
History of the DXY
The DXY was first created in 1973 after the establishment of the Bretton Woods agreement which abandoned the gold standard. The index has since been modified just once when the Euro was established as the official currency of the EU.
The DXY commenced with a value of 100 in 1973. The Index above 100 signals that USD is stronger than the basket compared to 1973 values. Meanwhile an index below 100 points to a weak dollar.
The current DXY value of 104 indicates that the USD is 4% above the value of the basket relative to its value in 1973.
During periods of major global financial upheavals, the DXY tends to drift away from 100. In the 1980s as the Fed hiked rates aggressively, the dollar’s value soared. Eventually, the dollar was intentionally weakened in an historical agreement known as the Plaza Accord.
Why would the US weaken its own currency?
In short, a strong currency is not always a good thing. A strong dollar made US goods less viable in global markets and led to a sharp increase in the US trade deficit. As such, weakening the dollar was in the best interests of not just US’s trading partners but also the US.
Another period of upheaval for the DXY was the 2008 global financial crisis. The USD was in crisis when Lehman Brothers collapsed amid the US housing crisis. The confidence in the dollar was shaken.
Comparatively, other countries were less severely affected. This pushed the DXY to its lowest level of 71.
Excluding these exceptional periods of time, the DXY trades around its base value. Movements in DXY are at times drive by policy changes in the US or its partner countries such as Japan, EU, UK, Canada, Switzerland, and Sweden. The real elephant in the room is the Fed policy. Fed decisions have an outsized effect on the DXY.
The DXY is not very volatile. Its 30-day annualized rolling volatility ranges between 5 and 10. However, major economic events can lead to a rise in volatility. Volatility spikes during periods of global crises or major events in the US (Fed Hikes) or EU (EU Debt Crisis) with both currencies having major weightage in the index.
DXY CORRELATION WITH OTHER ASSET CLASSES
Fed Funds Rate
Although not tightly correlated, Fed Funds rate has a major impact on the DXY. Higher rates make the dollar more attractive which leads to it strengthening. However, as other major central banks usually move in tandem with the Fed, rates in the partner countries also rise dampening the buoyancy in DXY.
Fed policy action has a major impact on the DXY at the beginning of shifts in policy. However, this effect soon fades as markets price in terminal rates according to expectations.
Fed & ECB Policy Divergence
The divergence of policy between ECB and Fed has a major impact on the DXY. As policies start to diverge (correlation between rates starts to decline), DXY experiences large directional moves.
2Y Treasury Yields
As treasury yields are derived from Fed Funds rate, the correlation between DXY and 2Y constant maturity treasury notes is similar. In general, both are positively correlated.
The correlation breaks during periods where rates grind lower, but the USD continues to rise. Case in point is the experience of 2020. When the US Fed drove rates to zero, the US dollar soared as the only credible haven. This is the classic dollar trap.
Furthermore, DXY and treasury yield correlation can break due to effects of economic policy action. For instance, in 2018, DXY remained muted despite rising treasury yields as markets were confident of the terminal rate and the Fed not hiking rates very aggressively.
FOMC MEETINGS AND THE DOLLAR INDEX
FOMC meetings decide the fate of interest rates. Typically, decisions move in tandem with expectations.
But when FOMC decisions diverge from consensus, impact on the DXY can be large. For instance, in its May 2023 meeting, markets anticipated the Fed to pause its aggressive hiking campaign against a backdrop of regional banking crisis. However, Fed mercilessly cranked up another 25bps driving DXY higher.
WHAT’S UP AT THE NEXT FOMC MEETING?
CME FedWatch tool highlights the probability of changes in FOMC rate as measured by 30-day Fed Fund futures pricing data.
For the next FOMC meeting on the 14th of June, CME FedWatch tool points to an 80% probability of no hike. For the meeting on 26th July, markets are pricing a 55% probability of a 25bps hike. This would take rates to 5.25%-5.5% which is expected to be the terminal rate.
In case Fed decides to hike in the June meeting, it could lead to a sharper upward move in the DXY.
COMMITMENT OF TRADERS REPORT
The Commitment of Traders report shows weekly changes in open interest by investor category. Institutional investors expect DXY to move higher as both managed money and small speculators have increased their net long positioning over the last three weeks.
TRADE SETUP
Market expectations have moved wildly from rate hike to no hike multiple times over the past two weeks.
Cooling inflation in April, signs of a weakening job market, anemic services data, credit tightening are shaping market consensus for a rate pause in June. However, if May inflation data, which is due a day before the FOMC meeting paints a different picture or the job market continues to remain strong, the Fed may throw in another rate hike.
Anticipating Fed move is difficult. Investors deploying a long straddle can potentially lock in gains from large moves in DXY if FOMC moves against consensus.
A long straddle is a delta-neutral options strategy that can be used to benefit from rising volatility in options. It involves simultaneously going long call and long put at the same delta. Delta-neutral makes the structure directionally agnostic to upside or downside moves. Loss on one leg will be offset by gains from the other leg when the underlying moves sharply.
Straddles are powerful in that they are long Vega which makes it gain not only from a directional move but also from volatility expansion. With uncertainty looming around Fed outcomes, volatility will likely spike heading into the meeting.
A delta neutral strategy would be difficult to run directly on DXY futures due to slim liquidity for these options on ICE.
As such, investors could consider long straddles in CME Euro FX options, CME Japanese Yen options, and CME GBP options to obtain similar exposure. These three majors represent 83% of the DXY and largely drive major moves in the DXY.
The above charts show the payoff for the straddle on each of these individual options. ATM strikes can provide higher profit potential with higher risk potential.
However, ~25 delta options have cheaper premium due to which the loss is limited at a lower level, consequently, 25 delta straddle would also require a larger price movement before the position is in the money. Moreover, the profit potential on these would also be lower due to wider strike levels.
A notable exception to these is the Japanese Yen put options which have noticeably lower IVs and are thus cheaper. Each of these pairs would have to move ~1.5% over the next two weeks for the position to make money.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
That is why, despite all its flaws, the dollar remains the ultimate haven currency. And the US Dollar Index (“DXY”) measures the performance of the US Dollar against a basket of six major currencies of USA’s major trading partners.
The DXY measures USD performance against currency majors. Euro, Japanese Yen, and the British Pound represent more than 80% of aggregate weight.
Intriguingly, the absence of emerging majors such as the Chinese Yuan (CNY) and the Australian Dollar (AUD), stands out. The DXY will likely be modified in the future to reflect shifting global dynamics.
History of the DXY
The DXY was first created in 1973 after the establishment of the Bretton Woods agreement which abandoned the gold standard. The index has since been modified just once when the Euro was established as the official currency of the EU.
The DXY commenced with a value of 100 in 1973. The Index above 100 signals that USD is stronger than the basket compared to 1973 values. Meanwhile an index below 100 points to a weak dollar.
The current DXY value of 104 indicates that the USD is 4% above the value of the basket relative to its value in 1973.
During periods of major global financial upheavals, the DXY tends to drift away from 100. In the 1980s as the Fed hiked rates aggressively, the dollar’s value soared. Eventually, the dollar was intentionally weakened in an historical agreement known as the Plaza Accord.
Why would the US weaken its own currency?
In short, a strong currency is not always a good thing. A strong dollar made US goods less viable in global markets and led to a sharp increase in the US trade deficit. As such, weakening the dollar was in the best interests of not just US’s trading partners but also the US.
Another period of upheaval for the DXY was the 2008 global financial crisis. The USD was in crisis when Lehman Brothers collapsed amid the US housing crisis. The confidence in the dollar was shaken.
Comparatively, other countries were less severely affected. This pushed the DXY to its lowest level of 71.
Excluding these exceptional periods of time, the DXY trades around its base value. Movements in DXY are at times drive by policy changes in the US or its partner countries such as Japan, EU, UK, Canada, Switzerland, and Sweden. The real elephant in the room is the Fed policy. Fed decisions have an outsized effect on the DXY.
The DXY is not very volatile. Its 30-day annualized rolling volatility ranges between 5 and 10. However, major economic events can lead to a rise in volatility. Volatility spikes during periods of global crises or major events in the US (Fed Hikes) or EU (EU Debt Crisis) with both currencies having major weightage in the index.
DXY CORRELATION WITH OTHER ASSET CLASSES
Fed Funds Rate
Although not tightly correlated, Fed Funds rate has a major impact on the DXY. Higher rates make the dollar more attractive which leads to it strengthening. However, as other major central banks usually move in tandem with the Fed, rates in the partner countries also rise dampening the buoyancy in DXY.
Fed policy action has a major impact on the DXY at the beginning of shifts in policy. However, this effect soon fades as markets price in terminal rates according to expectations.
Fed & ECB Policy Divergence
The divergence of policy between ECB and Fed has a major impact on the DXY. As policies start to diverge (correlation between rates starts to decline), DXY experiences large directional moves.
2Y Treasury Yields
As treasury yields are derived from Fed Funds rate, the correlation between DXY and 2Y constant maturity treasury notes is similar. In general, both are positively correlated.
The correlation breaks during periods where rates grind lower, but the USD continues to rise. Case in point is the experience of 2020. When the US Fed drove rates to zero, the US dollar soared as the only credible haven. This is the classic dollar trap.
Furthermore, DXY and treasury yield correlation can break due to effects of economic policy action. For instance, in 2018, DXY remained muted despite rising treasury yields as markets were confident of the terminal rate and the Fed not hiking rates very aggressively.
FOMC MEETINGS AND THE DOLLAR INDEX
FOMC meetings decide the fate of interest rates. Typically, decisions move in tandem with expectations.
But when FOMC decisions diverge from consensus, impact on the DXY can be large. For instance, in its May 2023 meeting, markets anticipated the Fed to pause its aggressive hiking campaign against a backdrop of regional banking crisis. However, Fed mercilessly cranked up another 25bps driving DXY higher.
WHAT’S UP AT THE NEXT FOMC MEETING?
CME FedWatch tool highlights the probability of changes in FOMC rate as measured by 30-day Fed Fund futures pricing data.
For the next FOMC meeting on the 14th of June, CME FedWatch tool points to an 80% probability of no hike. For the meeting on 26th July, markets are pricing a 55% probability of a 25bps hike. This would take rates to 5.25%-5.5% which is expected to be the terminal rate.
In case Fed decides to hike in the June meeting, it could lead to a sharper upward move in the DXY.
COMMITMENT OF TRADERS REPORT
The Commitment of Traders report shows weekly changes in open interest by investor category. Institutional investors expect DXY to move higher as both managed money and small speculators have increased their net long positioning over the last three weeks.
TRADE SETUP
Market expectations have moved wildly from rate hike to no hike multiple times over the past two weeks.
Cooling inflation in April, signs of a weakening job market, anemic services data, credit tightening are shaping market consensus for a rate pause in June. However, if May inflation data, which is due a day before the FOMC meeting paints a different picture or the job market continues to remain strong, the Fed may throw in another rate hike.
Anticipating Fed move is difficult. Investors deploying a long straddle can potentially lock in gains from large moves in DXY if FOMC moves against consensus.
A long straddle is a delta-neutral options strategy that can be used to benefit from rising volatility in options. It involves simultaneously going long call and long put at the same delta. Delta-neutral makes the structure directionally agnostic to upside or downside moves. Loss on one leg will be offset by gains from the other leg when the underlying moves sharply.
Straddles are powerful in that they are long Vega which makes it gain not only from a directional move but also from volatility expansion. With uncertainty looming around Fed outcomes, volatility will likely spike heading into the meeting.
A delta neutral strategy would be difficult to run directly on DXY futures due to slim liquidity for these options on ICE.
As such, investors could consider long straddles in CME Euro FX options, CME Japanese Yen options, and CME GBP options to obtain similar exposure. These three majors represent 83% of the DXY and largely drive major moves in the DXY.
The above charts show the payoff for the straddle on each of these individual options. ATM strikes can provide higher profit potential with higher risk potential.
However, ~25 delta options have cheaper premium due to which the loss is limited at a lower level, consequently, 25 delta straddle would also require a larger price movement before the position is in the money. Moreover, the profit potential on these would also be lower due to wider strike levels.
A notable exception to these is the Japanese Yen put options which have noticeably lower IVs and are thus cheaper. Each of these pairs would have to move ~1.5% over the next two weeks for the position to make money.
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
Full Disclaimer - linktr.ee/mintfinance
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