The US Dollar Index: Reasons for its Significant Rise and Future Trends
Author: ZHANG Ming and CHEN Yinmo
The US Dollar Index (USDX) recently hit a 20-year high. It had grown from 95.97 by the end of 2021 to 106.49 on July 27，2022，by an incredible 11%. On July 14，2022，it exceeded 109，hitting an intraday high of 109.29，the highest since 2002.
Why the USDX keeps rising?
The USDX measures the exchange rates of the US dollar relative to a basket of other currencies，reflecting the comprehensive strength of the US dollar in the foreign exchange market. The continued rise of the USDX can be attributed to four factors.
First，significant depreciation of all six component currencies of the USDX: against the US dollar，the euro depreciated by 10%，the yen by 19%，the British pound by 10%，the Canadian dollar by 1%，the Swedish krona by 14%，and the Swiss franc 5%，between the end of 2021 and July 27，2022. The euro，Japanese yen，and British pound weigh as heavily as 83.1% in the calculation of the USDX while all three currencies have hit their 20-year lows against the US dollar.
Second，record high inflation in the US has forced the Federal Reserve to embark on an aggressive interest rate hike. It also means the US interest rates are rising faster than elsewhere and the USDX is strengthening. This year，the Consumer Price Index (CPI) in the US went up by 8.3%，8.6%，and 9.1% in April，May and June respectively. To tame the growing inflation，the Fed started one of the biggest interest rate hikes since the early 1990s. The fed raised the policy rate by 25，50，75 and 75 in March，April，May，and June respectively. Meanwhile，the Fed plans to accelerate balance sheet reduction in September，raising the monthly cap on mortgage-backed securities (MBS) to US$35 billion and that on treasury securities to US$60 billion. The interest rate hike is expected to drive US bond yields to continue to climb. The yield on the 10-year US treasury securities surged from 1.66% to 3.49% from January 4 to June 14，2022. The possibility of USDX continuing to grow cannot be ruled out，despite the potential slow-down of interest rate hikes，due to the reason that the interest rate raise and balance sheet reduction have not ended.
Third，risk aversion climbed，fueled by the uncertainty from the Russia-Ukraine conflicts. The length and impacts of the conflicts have far exceeded market expectations，raising risk aversion that has led investors to increase their holdings of safe-haven assets such as the US dollar. The global macroeconomic and geopolitical uncertainty enable the demand for the US dollar will remain high. Therefore，the USDX is expected to maintain its strength.
Fourth，the prospect of a recessive global economy results in the US dollar，a countercyclical asset，remain relatively strong. Historically，the US dollar often goes from bullish to bearish after significant rebounds in the global economy. In July 2022，the IMF lowered its global economic growth forecast for 2022 from 3.6% to 3.2% in its World Economic Outlook report，given the outbreak of the Russia-Ukraine conflicts as well as the interest rate hikes and balance sheet reduction by the Fed. The global economy is transitioning from “persistent stagnation” to stagflation featured by low growth and high inflation. In such an environment，a rapid decline in the dollar index is unlikely in the short term.
Why the Euro Depreciated Significantly against the US Dollar?
The euro has a 57.6% weight in the USDX. The euro depreciated sharply against the dollar in the second quarter of 2022，hitting a nearly 20-year low. The euro’s sharp depreciation against the US dollar can be attributed to the following reasons.
On the one hand，a sharp rise in the prices of energy and other commodities triggered by the Russia-Ukraine conflicts and the global supply chain disruption caused by the COVID-19 pandemic have led to severe inflation that weakened the economy in the eurozone. In 2022，Harmonized Indices of Consumer Prices (HICP) in the eurozone saw a year-on-year growth of 7.4%，8.1% and 8.6% in April，May，and June respectively. To curb the raging inflation，the ECB raised the main refinancing operations rates to 0.50%，the marginal lending facility rates to 0.50%，and the deposit facility rates to 0.00% effective from July 27，2022. This has been the first interest rate hike in the eurozone since July 2011. According to Sheng Songcheng (2022)，the euro is likely to continue weakening if Europe remains unable to tackle its energy shortage as the Ukraine crisis continues.
On the other hand，the increasing political uncertainty in Europe also brought considerable uncertainty to the economic growth of the Eurozone. British Prime Minister Boris Johnson announced his resignation on July 7，2022. Italian Prime Minister Mario Draghi handed in his resignation on July 21，2022.
Due to the combined impacts of the above political volatilities，for the first time in 20 years，the exchange rate between the euro and the US dollar has reached parity and the euro-dollar exchange rate was quoted at an intraday low of US$0.9998 on July 12，2022.
Why the Japanese yen depreciated significantly against the US dollar?
The Japanese yen，despite its long track record of being a safe-haven asset，depreciated sharply in 2022，making it one of the worst-performing currencies in 2022. The yen weighs 13.6% in the composition of the USDX. The major reasons for the yen’s recent rapid depreciation are as follows.
First，the direct cause