What drives the dollar index?

“Never let the facts get in the way of a good story” might be good advice in journalism, but it is inexcusable in the financial markets. How many other fields have such a wealth of readily available facts? Yet market myths and legends abound. Consider the primary one about the U.S. dollar — that its long-term depreciation is connected to the so-called “twin deficits” of the current account and the federal budget. But is there any evidence supporting this conclusion?

Let’s slay one dragon at a time here, beginning with the current account deficit. The current account, reported quarterly as part of the gross domestic product (GDP) statistics, includes the monthly merchandise trade deficit as well as trade in services and official transactions. Because the U.S. tends to be a net exporter of services, this number is a more complete and accurate measure of the U.S. external balance. Many people believe a strong dollar leads to deeper current account deficits as a percentage of GDP, and that a weaker dollar either reduces this deficit or leads to a surplus. However, It shows just how weak the relationship between the dollar index (DXY) and the current account deficit has been since the start of the floating exchange-rate era in the early 70s.

The dollar’s early-80s surge certainly preceded a deepening of the current account deficit — but that is not the direction of causality assumed by those who would have you believe a deeper current account deficit causes a weaker buck because it puts excess dollars into world markets.

Has this happened? Hardly. The deepening deficit of the mid to late 70s preceded a surge in the DXY, and the narrowing deficit in the late 80s preceded a further weakening in the dollar index.

Most telling, though, is the post 1991 pattern. The U.S. recorded its last quarterly current-account surplus in the immediate aftermath of the Persian Gulf War, on the basis of foreign government contributions for that war effort (the last month of a merchandise trade surplus was April 1976). Since then the current account deficit has continually deepened, but the DXY weakened between 1992 and 1995, strengthened between 1995 and 2001, weakened again into the end of 2004, and strengthened in 2005.

This would strongly suggest currency traders look elsewhere for what drives the dollar.