The Dollar Index, or DXY, is one of the most important and decisive gauges in every financial market in the world. If you picture a financial market as a large ecosystem, the Dollar Index plays the role of the “main liquidity current” that sets the direction for every other asset's movement. In this article, we'll look in simple, practical terms at what this index is and why its changes turn every global market upside down.
What is the Dollar Index?
The Dollar Index is a mathematical coefficient that measures the strength of the U.S. dollar's value against a basket of six major world currencies. It was introduced by the Federal Reserve in 1973 and has been known ever since as the primary benchmark for assessing the dollar's strength. The currencies in this basket and their weights are as follows: the euro at 57.6%, the Japanese yen at 13.6%, the British pound at 11.9%, the Canadian dollar at 9.1%, the Swedish krona at 4.2%, and the Swiss franc at 3.6%. Since the euro holds more than half of this index's weight, the EUR/USD pair behaves in a nearly inverse and very similar fashion to the DXY.
Why does the Dollar Index dominate every global market?
The U.S. dollar is the world's primary reserve currency, the base currency in the international banking settlement system, and the primary currency for pricing energy and essential commodities. When the DXY rises, it means the dollar has become scarcer and more expensive globally; and when it falls, it means dollar liquidity has become abundant and cheaper. These liquidity shifts shape DXY's relationship with four major global markets.
The Dollar Index's relationship with gold, commodities, stocks, and crypto
Its relationship with gold is sharply inverse: when the DXY rises, returns on dollar deposits and bonds become attractive, and investors sell their gold to buy dollars; when the DXY falls, the dollar's value has dropped, and investors buy gold to preserve their asset value. It also has an inverse relationship with commodities and energy, since nearly every strategic commodity in the world is priced in dollars; a stronger dollar means buying commodities becomes more expensive for the rest of the world, lowering global demand. With the stock market, it usually has an inverse relationship too, since a rising DXY is often the result of higher interest rates, which makes borrowing expensive for listed companies. And the cryptocurrency market, the riskiest financial market in the world, depends the most on risk appetite and surplus liquidity; a rising DXY signals money being pulled in and financial tightening, and every major crypto bear market has coincided with periods of a rising DXY.
DXY divergence with gold and Bitcoin: a signal for a market turn
Roughly 90% of the time, when the DXY is rising, gold and Bitcoin are falling, and vice versa; but when this natural relationship breaks down for a while, it means the market is putting out an important signal of a coming price reversal. To find this signal, we place two charts side by side on the same timeframe (say, 4-hour or daily). If the Dollar Index sets a new higher high, but Bitcoin or gold, instead of making a lower low, make a higher low, it means sellers have run out of steam and powerful buyers are accumulating; this is a strong bullish signal. Conversely, if the Dollar Index sets a lower low, but Bitcoin or gold fail to make a new high and instead form a lower high, it means new buying demand has dried up, and this is a dangerous bearish signal.
To get a real signal from these divergences, put both charts on higher timeframes like the 4-hour or daily, since divergences on timeframes below 15 minutes are usually just noise. When you spot a divergence, don't enter the trade immediately; wait for a strong reversal candle to form in the direction of the divergence, then enter the trade and place your stop loss just behind the low or high formed at the divergence. Bitcoin and gold usually behave “smarter” than DXY in showing a divergence; very often, before economic news is released or the DXY changes direction, Bitcoin or gold whales have already made their purchases. Using DXY divergence with other assets gives you the perspective to step out of the role of a simple technical trader and look behind the scenes of liquidity flow like a macro investor.