Recently, while watching the markets, I truly understood why so many people keep an eye on the U.S. dollar index. To be honest, at first I didn’t really understand what this thing was useful for, but later I realized it almost influences every decision we make in investing.

Simply put, the U.S. dollar index is an indicator used to measure the strength of the dollar relative to other major currencies. It tracks the exchange rate changes of the dollar against six currencies, which are the euro, Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc. Among them, the euro has the highest weight, accounting for 57.6%, which is why European economic data directly affects the trend of the dollar index.

You can think of the dollar index as a thermometer for global capital flows. When the dollar appreciates, it means the dollar is strengthening, and hot money flows into the U.S. market, increasing the number of people buying U.S. stocks and bonds. Conversely, when the dollar depreciates, capital may flow into Asia or emerging markets, giving Taiwan stocks and the New Taiwan dollar a chance to benefit.

The way the dollar index is constructed is actually quite interesting. It’s not simply an average of the six currencies, but uses a “geometric weighted average method,” based on each country’s economic size and trading volume to determine the weights. The euro has the highest proportion because the Eurozone has 19 countries using it, with a large economic size. The Japanese yen ranks second because Japan is the third-largest economy in the world, and the yen’s interest rates are very low, often used as a safe-haven tool. The other four currencies combined account for less than 30%.

I found that the most practical aspect of the dollar index is that it can help you predict capital flows. For example, when the Federal Reserve raises interest rates, the dollar index usually rises because high interest rates attract global capital into the U.S. At this time, gold prices tend to fall because the cost of buying gold increases. Conversely, when interest rates are cut, the dollar weakens, and gold tends to rally.

The relationship between U.S. stocks and the dollar index is more complex; it’s not simply positive or negative correlation. Sometimes, a rising dollar can boost U.S. stocks because of capital inflows; but if the dollar becomes too strong, it can hurt U.S. export companies and drag down the stock market. The 2020 pandemic was like this—when global stocks crashed, the dollar actually surged to 103, but later, after the Fed flooded the market with money, the dollar quickly fell back to the 93s.

For us Taiwanese investors, a decline in the dollar index is actually good news. When the dollar weakens, capital flows into Taiwan stocks, and the New Taiwan dollar tends to appreciate. But if you hold U.S. stocks or dollar deposits, you need to watch out for exchange rate risk, because a depreciating dollar means you get fewer Taiwan dollars when converting back.

There’s a detail many people overlook. The Federal Reserve itself actually more often refers to the “Trade-Weighted U.S. Dollar Index,” rather than the general dollar index reported by the media. The trade-weighted index includes over 20 currencies, including more Asian emerging market currencies like the Chinese yuan, Taiwan dollar, and Korean won, which more accurately reflect the dollar’s strength in global trade. But if you’re just an average investor, watching the dollar index is enough; it’s the most common and easiest data to access.

My current habit is to check the dollar index’s trend before each market session. If the dollar index is high, I tend to be more cautious about gold and emerging market investment opportunities. Conversely, if it’s low, I look for other opportunities. Mastering the changes in the dollar index is really a fundamental skill in investing, especially when trading forex or holding cross-border assets. This indicator can help you avoid many pitfalls.