Please explain the significance of Dollar Index and how it is crucial for Indian and Global Markets

What is dollar index? Dollar index is the index of values of US dollar relative to a basket of foreign currencies. The basket of currencies include Euro, Pound sterling (GBP), Canadian Dollar (CAD), Swiss Franc (CHF), Swedish Kroner (SEK) and Japanese Yen. Though the Indian Rupee (INR) is not in the basket of currencies in the dollar index, the dollar index has a big impact on all the four markets, currency market, commodity market, bond market and equity market. We will discuss the impact of dollar index on each of these markets one by one. Therefore traders in all these markets should monitor the dollar index

1) Currency Market: The impact of dollar index on currency market is quite obvious. When the dollar index rises, other currencies including the INR falls relative to the USD. On the other hand, when the Dollar Index falls the INR appreciates with respect to the USD

2) Commodity Market: Commodity prices are usually inversely related to the dollar index. Therefore, when the dollar index rises, prices of commodities like crude, metals etc falls and vice versa. Gold has a strong inverse relationship with dollar index. In the last 3 years, dollar index has risen by around 20%, while gold has fallen by around 20%.

3) Bond Market: Dollar index also has an impact on Indian bond markets, though the impact is not as strong as that on currency and commodity markets. When dollar index falls, Foreign Institutional Investors (FIIs) invest more in bonds, causing bond yields to fall and bond prices to rise. On the other hand if the dollar index rises, FIIs may sell bonds causing bond yields to rise and bond prices to fall. Dollar index has an indirect impact on bond markets. When dollar appreciates versus the rupee, imports become more expensive causing current account deficit to increase. Increase in the current account deficit causes bond yields to rise and bond prices (especially long maturity bonds) to falls. Fall in dollar index has the opposite effect on current account deficit and bond prices. The impact of dollar index on debt mutual fund returns is exactly the same as the impact on bond market.

4) Equity Market: Dollar index also has an impact on Indian equity markets. However, the impact of dollar index is more pronounced in the short term. In the long term, other factors have a bigger impact on equity returns. Let us discuss the short term impact of dollar index on equity market. When dollar index falls, FIIs invest more in Indian equities because they expect higher dollar returns (with appreciation of INR versus USD) and when it rises, they invest less because they expect lower dollar returns (with the depreciation of INR versus USD). Let us understand the significance of the Dollar Index in more details, as far as equity markets are concerned and impact of Dollar Index on Indian equity prices will become clear to you. Rise in dollar index signifies increasing risk aversion in global investor sentiments. Why? The safest asset in the whole world among all asset classes is believed to be the US Treasury bonds (US Government bonds). If the investors are uncertain about the global economy and in most asset classes, they will seek safety of their money by investing in US Treasury bonds. To buy US Treasury bonds, investors will have to buy dollars and as a result the dollar index will rise. Therefore, rise in dollar index signifies risk aversion. On the other hand, fall in dollar index, signifies optimism about the global economy and investors will sell US treasuries to buy other assets, including Indian equities. However, as discussed earlier, please remember that, the dollar index impacts equity returns only in the short term. In the long term, factors like India’s GDP growth, earnings growth of companies, Government policies, political stability, global macro-economic factors etc has a bigger impact. Also please note, that, even in the short term, dollar index has different impact on different sectors. For example, rise in dollar index are likely to cause a drop in share prices of companies in cyclical sectors (domestic consumption oriented sectors, e.g. Banking, Automobiles, Oil and Gas, Capital Goods, Metals etc). However, rise in dollar index will be good for export oriented sectors like Technology, Pharma etc, because exports will become more competitive with depreciation of the INR. Share prices of companies in these sectors are likely to rise with rise in dollar index.

The Dollar Index follows chart patterns and therefore technical analysis can be applied to dollar index. There are support and resistance levels in dollar index too. Therefore, if you are a short term investor or trader in any of the four markets, you will benefit from tracking the dollar index and applying technical analysis tools. Hope we have been able to explain the significance of dollar index with respect to different markets and how you can use it to maximize your trading profits. Feel free to write to us, if you have more questions on dollar index.