March 27, 2024
Barring a few outliers, most markets have been content to take it easy so far in what is set to be a relatively uneventful week, economically speaking. Given last week’s hysteria one can hardly blame them. As the month draws to a close, US indices made minor pullbacks from the highs of the previous week, the DJI putting in losses of 0.41% and 0.08% over the past two sessions. The S&P 500 drifted 0.31% and 0.28% to the downside over the same period; the Nasdaq Composite closed 0.27% and 0.42% in the red.
Apparently the German DAX didn’t get the memo however, printing its sixth consecutive all time high yesterday. Other than the prospect of future interest rate cuts for the Euro, the reasons for the continued push northwards aren’t immediately apparent.
Gold made an attempt to forge a path higher on Tuesday, gaining $30 intra-day to tap $2,200 an ounce. The attempt was ultimately fruitless unfortunately, subsequently falling back to finish the day a mere 0.32% in the black.
The only real possible spur to markets this week will arrive on Thursday in the form of jobless claims, courtesy of the US Department of Labor. A day later will see the publication of the core PCE price index, the Federal Reserve’s favourite inflation gauge, however most markets are closed due to Good Friday so we’ll have to wait until next week to see the full reaction to those figures. Fed Chair Jerome Powell will speak in San Francisco on the same day.
The mid-week frenzy seen across stock markets gave way to a comparatively mundane Friday session last week. The dizzying heights experienced by many major indices followed some very encouraging wording from central banks the world over. We even had a surprise interest rate cut, courtesy of the Swiss National Bank, the first but certainly not the last we will see this year. Although the Bank of Japan is attacking its economic woes from a different angle, its decision to abandon yield curve control effective immediately is equally momentous.
After printing a precarious looking candle on Thursday, gold appeared unwilling to mount any kind of defence during the following session, losing 0.74% on Friday to end the week at $2,165 an ounce.
Despite Federal Reserve Chair Jerome Powell promising no less than three interest rate cuts this year, every other major central bank has promised similar reductions in their own respective currencies, so the Dollar sell-off on Wednesday was short-lived. After some losses following the Fed’s comments, the DXY gained 0.57% and 0.44% on Thursday and Friday respectively, latching onto strong US macroeconomic data instead.
The final week of the month will be a relatively uneventful one from a data perspective. The economic calendar has little to offer, with the exception of US jobless numbers on Thursday. A reminder that markets throughout the western hemisphere will be closed in observance of Good Friday this week and will remain so during the following Easter Monday.
The latest Federal Reserve meeting concluded with an unexpectedly optimistic outlook. Following the meeting, Chairman Jerome Powell reassured markets that although the benchmark rate will remain steady at 5.5% for the time being, this year will see no less than three interest rate cuts. During the press conference, Powell addressed the surprising uptick in inflation seen at the beginning of the year, but insisted that the Fed’s outlook on the economy had not fundamentally changed because of it, stating that the path to 2% inflation may be a bumpy one.
The statement was music to the ears of many, sparking a market-wide rally that culminated with the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite all establishing consecutive all-time highs on Wednesday and Thursday.
The euphoria was not contained to US markets. Following a mid-week bank holiday in Japan, the Nikkei 225 opened high on Thursday and maintained momentum to close out the session 2% higher, printing yet another fresh record for the Japanese index. The Bank of Japan recently announced an increase in its own benchmark rate but the signs of strength in the Japanese economy continued to outweigh the prospect of tighter monetary conditions.
Following the decision of the Federal Reserve, it was the turn of the Bank of England and the Swiss National Bank to chime in with their own commitments. Whereas the former surprised no one by maintaining the current 5.25% target, the latter caught traders off guard after the SNB announced a surprise cut from 1.75% to 1.5%. The decision sent the Swiss Franc plummeting to the downside, USDCHF gaining 1.2% on Thursday.
Prospects of lower rates on the Dollar no doubt contributed to the rally in gold seen over the last two days. Prices surged up to $2,186 an ounce on Wednesday and initially continued to drive higher the following day, XAUUSD reaching as high as $2,222. Short-lived however, as prices came crashing back down to finish 0.2% in the red on Thursday, in a move reminiscent of the wick seen back in early December.
The Dollar Currency Index serves as a crucial metric for establishing the relative strength of the US Dollar within a wider macroeconomic landscape. The DXY, or Dixie as it is sometimes referred to, offers instant insight on the performance of the Dollar compared to other currencies. Let us take a closer look at it.
BRETTON WOODS
As with many things, the World Wars were the spark that set things in motion. After the First World War, Europe lay in ruins; it was time to rebuild. The Treaty of Versailles, written by the victorious parties, essentially passed the entire bill of the conflict to Germany, inevitably bankrupting them. This was a major contributing factor to the advent of the Second World War, which would lead to similarly destructive consequences in Europe and further afield.
Determined not to repeat the “beggar thy neighbour” policies of the past, economists and leaders from around the world set out to establish an international monetary framework as the basis for reconstruction. During the closing stages of the war, delegates gathered at Bretton Woods, New Hampshire, to establish how the new financial system would function:
- Firstly, the US Dollar would be fixed to $35 per troy ounce of gold
- Secondly, each member country of the agreement would guarantee convertibility of their own money to the Dollar according to pre-established currency pegs.
The above would result in the USD becoming the de facto world reserve currency. As an addendum, the conference also resulted in the creation of the International Monetary Fund (IMF) as well as other entities that would go on to form the World Bank.
Over the next few decades, the system worked incredibly well. Perhaps a little too well. Due to its convertibility to gold, the Dollar became very attractive, both domestically and internationally. To keep pace with increased demand, more Dollars were printed. So much so that by the 1970s, there were four times more Dollars in circulation than could be backed up by the gold reserves of the time. This meant that the Dollar was extremely overvalued, which was a problem in its own right, but led to the other issue of huge gold outflows out of the US.
By the time Richard Nixon took office, the situation was untenable. The system that was arguably responsible for post-war economic stability and growth had to go. The Bretton Woods system was abandoned and the Dollar taken off the gold standard. This created a problem: by severing the tether between the Dollar and gold, suddenly there was nothing to properly ground the value of the American currency, and by extension, every other currency pegged to it.
THE DXY
If a currency is not tied to anything, then what gives it value? The many answers to this question fall outside of the scope of this article so let us turn instead to the answer provided by the Federal Reserve. Their solution to this new problem was to create an index that weighed the strength of the Dollar against the currencies of the US’ most common trading partners.
At the time of its implementation in 1973, this meant the inclusion of the following 10 currencies: the Japanese Yen, the Canadian Dollar, the Deutschmark, the Pound Sterling, the Italian Lira, the Dutch Guilder, the Swedish Krona and the French, Belgian and Swiss Francs. After the adoption of the Euro by many European nations around the turn of the millennium, the basket consolidated from 10 currencies down to the current six according to the following ratio:
Taking the above weightings into account, the formula for calculating the DXY is as follows:
One may notice the negative exponent for the Euro and Cable. We leave the reasoning as to why as an exercise for the reader. The purpose of the constant is to peg the first calculation to a value of 100. The index is therefore to be read as follows: a value below 100 is to be understood as an indication of a weak Dollar; and the obvious corollary.
Although established by the Fed, the task of calculating the DXY currently falls to the Intercontinental Exchange (ICE), which introduced a tradeable futures contract tied to the index back in 1985. It would be during this very year that the DXY printed its highest ever value, coming in just shy of 164.
In contrast, the period surrounding the 2008 financial crisis was characterised by lower interest rates in the US compared to other countries, comparatively devaluing the Dollar and causing the DXY to fall as low as 70 in the first half of that year.
CRITICISM
The index has not changed in its composition since its introduction half a century ago. The Euro merely substituted the currencies it replaced, taking their combined weighting as its own. This is the source of much of the criticism currently levelled against the DXY. The world has changed considerably since 1973, economically and otherwise. Let us remind ourselves that the currency basket of the DXY was defined by the largest trading partners of the United States at the time, which as of 2021 stood as follows:
As we can see, the composition of the DXY doesn’t follow the above chart at all. Despite making up 57% of the weighting of the basket, the truth is that only 15% of US trade occurred with Eurozone countries. Meanwhile, due to its strongly emergent economy and solid manufacturing base, trade with Mexico continues to ramp up, now challenging China and Canada for the top spot.
If the index is meant to be a reflection of the strength of the Dollar on the world stage, then why does it not include the Mexican Peso, or indeed the Chinese Renminbi, or even the Korean Won? Conversely, and with absolutely no offense to Sweden, is the inclusion of the Swedish Krona really justified in this day and age?
The other, perhaps more fundamental criticism, is that none of this matters because none of the currencies mentioned in this article have any inherent value anyway. By definition, the DXY tells us the relative value of the Dollar compared to other currencies. The problem being that all of these currencies are locked in a race to the bottom, relentlessly eroded by inflation, year after year. 35 bucks certainly won’t buy an ounce of gold anymore.
Overly harsh criticism no doubt. The DXY remains ubiquitous in the financial world in no small part because of its use to traders. Given that the USD is on one side of almost 90% of all forex trades, it can more than justify its own index. Although perhaps one more grounded in the present day.
We have our first shift in monetary policy. Yesterday, the Bank of Japan announced that it would raise interest rates from -0.1% to 0%, terminating a period of negative rates that has endured since 2016. Yield curve control, the tool by which the central bank achieved its rate targets, is also coming to an end. The move comes off the back of encouraging signs of wage growth, the most robust seen in decades, which is exactly the sign Governor Kazuo Ueda has been looking for to trigger the shift.
The Yen reacted exactly as one might expect, blasting through 150 to finish the session over a percent weaker versus the Dollar. The Nikkei 225 gained just enough to close above the 40k mark, up 0.66% by Tuesday’s close. Japanese markets are closed today so we’ll have to wait until Thursday to witness the continued impact of the BoJ’s decision.
Later today, it falls to the Federal Reserve to make a move of its own, although anything other than maintaining the current 5.5% figure would be very surprising. Having said that, given the strong performances in US stocks on Tuesday, it appears some market participants are expecting a rate cut in the not-too-distant future. In anticipation of the imminent decision, the DJI, S&P 500 and Nasdaq Composite gained 0.83%, 0.56% and 0.39% respectively during yesterday’s session.
Sentiment continued to improve in oil markets early this week as a result of increasing demand forecasts, with Brent Crude nudging above $86 a barrel, WTI reclaiming $82.
Today may well be the calm before the storm for currency markets as a series of central bank interest rate decisions are to be announced later in the week. The Bank of Japan and Reserve Bank of Australia kick things off on Tuesday; the Federal Reserve press conference is the main event of the week on Wednesday and finally the Bank of England and Swiss National Bank will have their say on Thursday. There is a sense of trepidation going into this week, and given the less than ideal inflation signals we witnessed recently the sentiment is probably deserved.
Stocks performed poorly at the end of last week, possibly in light of the above. The Nasdaq Composite lost 0.96% by Friday’s close, the DJI was down half a percent and the S&P 500 closed 0.65% in the red.
Interestingly, the Nikkei 225 shot up during this morning’s session, already up over 2.5% by lunchtime. Many expect the BoJ to be the first out of the gate when it comes to rate hikes. The central bank has maintained ultra-low interest rates since the late 1990s in an effort to encourage spending and investment in the Japanese economy, even dipping into negative figures since 2016. Expectations are for a move from -0.1% to 0%, possibly confirmed tomorrow, possibly later. Although an interest rate hike isn’t typically a buy signal for stocks, such a pivot would reflect a huge boost in the confidence in the Japanese economy overall.
Despite this week being all about currencies, the DXY has yet to make a move early this morning. As markets gradually wake up expect some jostling for position as traders make their bets for the upcoming monetary policy announcements.
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