Fundamentals: Why do investors track the US dollar index, and what is it usually interpreted in conjunction with?
- The EPF Atlas
- Sep 16, 2025
- 4 min read
Author: Hoang Minh Tue
It is common knowledge that the USD is the world’s reserve currency, therefore its fluctuations often coincide with major shifts in global markets. While a weaker US dollar usually correlates with rising global liquidity and risk asset prices, this relationship is not purely causal, rather, it is mediated by monetary policies, credit cycles and investor behaviour.
A weaker US dollar can stimulate global liquidity through several transmission mechanisms. When the dollar depreciates, the real burden of dollar-denominated debt would fall, allowing government and firms in emerging markets to expand, invest and take on more risk. BIS data showed that the total debt in dollars of emerging markets exceeds 4 trillion - thus a depreciation of the US dollar can greatly lower the cost of global trade and support export-driven economies. An UBS Global Research report (2020) found that over the past two decades, emerging market equities have exhibited a strong negative correlation of roughly ‒0.62 with the US dollar, particularly during periods of USD weakness, supporting the view that a softer dollar tends to coincide with stronger EM equity performance. In addition, the post 2020 pandemic cycle illustrates this vividly, as the DXY declined by about 10%, global risk assets recovered with a short lag and a broad upswing followed into 2023 (IMF, 2017)
Beyond macroeconomic correlations, investors track the DXY because it has direct implications for portfolio management and hedging strategies. Since oil, gold and raw materials are priced in USD, an increase in its strength can depress these commodity prices. As a result, inflation expectations are lower and influence central bank decisions to cut interest rates. (Hofmann et al., 2022) Secondly, the relative strength of the US dollar can affect capital flows. An evaluation of the US dollar causes investors to pull their money out of emerging markets and move back into US assets such as treasuries or cash. A typical case of this capital outflow phenomenon is the 2013 “Taper Tantrum”, where the Fed signalled it would slow down quantitative easing. As the dollar strengthened, money rapidly left countries such as India, Brazil, and Indonesia - causing their currencies to crash and pressure central banks to raise interest rates. In this way, tracking the DXY helps investors better understand the future direction of stocks & bond prices via predicting commodity prices and capital flows.
Timing is a crucial reason why investors usually monitor the DXY closely, as it provides early signals for when to adjust portfolio positioning. For instance, during the 2022-2023 cycle, the dollar’s value peaked in September 2022 which is weeks before the global equity market bottomed. This signals portfolio managers to buy risk assets early on and capture more upside. Similarly, macro hedge funds track the dollar to anticipate when to rebalance their currency hedges, since a stronger dollar can erode foreign equity returns. For example, in 2022, the Japanese yen weakened by more than 20% against the US dollar as the Fed raised interest rates significantly while the Bank of Japan (BoJ) kept its policy constant. For US investors holding Japanese equities through the MSCI Japan Index, this appreciation of the exchange rate causes returns in USD to become negative - because converting yen back into dollars resulted in fewer dollars. Many global asset managers such as BlackRock and Vanguard offered currency-hedged Japan ETFs (with exchange rate locked in contracts) to offset the 20% drop, which outperformed their unhedged counterparts by a wide margin during this period.
Despite the historical correlation between depreciation of the US dollar and rising global liquidity, the dollar, and particularly the US Federal Reserve’s balance sheet expansions, is not the sole causal driver of risk asset performance. Firstly, China’s credit cycle and other central banks now play just as big a role in setting global liquidity. For example, in 2016, Chinese authorities imposed a major credit stimulus that preceded the synchronised global recovery of 2017, even though the US dollar remained relatively strong through much of the period. (IMF, 2017) As China accounts for a significant share of global commodity demand and emerging market growth, its credit cycle can partially determine global liquidity conditions and set the tone for global risk appetite. Additionally, research from BIS (2022) confirms that DXY movements alone have limited predictive power for global risk assets, finding that over 60% of the variance in global liquidity is explained by domestic monetary policy actions and credit cycles rather than currency shifts. For example, during the 2014-2016 period, the dollar appreciated sharply as US interest rate expectations rose, yet global equities performed well due to aggressive quantitative easing in Europe and Japan which substantially increased liquidity in the global market. For investors, this means that DXY should be interpreted in conjunction with measures such as global M2 growth or foreign countries’ policy shifts in order to predict the market.
In short, these dynamics suggest that the US dollar’s movements often coincide with turning points in global financial conditions, offering analysts a useful, though not definitive signal of shifts in risk appetite and liquidity. For robust market analysis, it should be interpreted alongside complementary measures such as global M2 growth, central bank balance sheet data, credit spreads, and major economies' credit cycle, which collectively provide a more complete picture of the forces shaping global liquidity and asset prices.
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