This is the only dollar index that matters

The US dollar has been on a tear.

This is a fairly uncontroversial statement that asserts the US dollar has been rising in value against other currencies.

But there are a few ways to measure this increase, and in a note to clients on Monday, Ellen Zentner at Morgan Stanley wrote that the only index of the dollar’s value that matters for the US economy and Federal Reserve policy is the Fed’s own broad trade-weighted dollar index.

In markets there are basically 3 dollar indexes, the Fed’s trade-weighted dollar (TWDI), the DXY dollar index, and “flow-based” dollar indexes such as the Dow Jones FXCM Dollar Index.

The main difference between the TWDI and the DXY, as Morgan Stanley outlines, is that the Fed’s measure simply weighs the US dollar against a far wider range of currencies than the DXY.

“Flow-based” indexes, meanwhile, can be based on financial market flows — which currencies people are exchanging for other currencies — rather than international trade, with Morgan Stanley noting that the Dow Jones FXCM dollar index is equally measured against the euro, the British pound, the Japanese yen, and the Aussie dollar.

But why does the dollar matter anyway?

Here’s Morgan Stanley:

The role of the USD in financial conditions is also significant. We find that a 1-month 1% increase in the nominal trade-weighted exchange value of the USD versus major currencies would add roughly 0.14 points to the Chicago Fed’s adjusted financial conditions index, indicative of substantially tighter financial conditions. To put it in perspective, a 10bp widening of the 2-year/3-month Treasury yield spread would have an equivalent impact on financial conditions.

And some, including economist Tim Duy, have argued that the Fed has effectively raised rates already because financial conditions have tightened, with the dollar’s rise playing a big part in this.

Last week’s move to devalue the yuan by the People’s Bank of China could also see the trade-weighted dollar further appreciate.

And while Fed officials have made clear they plan to raise interest rates this year, “King Dollar” could, it seems, stand in the way.

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