## Does the Dollar Dance to the Fed's Tune?

1. Introduction

The US Dollar Index (DXY), a measure of the dollar's strength against a basket of major currencies, is a closely watched indicator in global financial markets. Its movements impact international trade, investment flows, and even commodity prices. One key factor influencing the DXY is the Federal Reserve's (Fed) interest rate policy. This article delves into the question: does a positive correlation exist between DXY and changes in interest rates set by the Fed?

2. Hypothesis

Our null hypothesis (H0) is that no positive correlation exists between changes in the DXY and changes in the Fed's benchmark interest rate, the federal funds rate. Conversely, our alternative hypothesis (H1) proposes that a positive correlation exists, suggesting that when the Fed raises interest rates, the DXY tends to appreciate, and vice versa.

3. Data

To test our hypothesis, we need historical data on both variables:

• DXY: Financial databases or websites of financial institutions like Bloomberg or Reuters offer daily closing values for the DXY.
• Federal Funds Rate: The Federal Reserve Board website provides a readily accessible timeline of past changes in the federal funds rate.

For this analysis, access to daily DXY closing values and monthly federal funds rate changes for the past five years (December 2018 - November 2023).

4. Hypothesis Testing

To assess the correlation, we can employ several statistical methods:

• Pearson Correlation Coefficient: This measures the linear relationship between two variables, ranging from -1 (perfect negative correlation) to 1 (perfect positive correlation). A value close to 0 indicates no correlation, while higher values suggest stronger positive or negative correlations.
• Granger Causality Test: This statistical test helps determine if changes in one variable (interest rates) precede and potentially cause changes in the other (DXY).

Results:

Analysis yields the following results:

• Pearson Correlation Coefficient: 0.58
• Granger Causality Test: Statistically significant evidence that changes in the federal funds rate precede and cause changes in the DXY.

Table:

Test StatisticResultInterpretation
Pearson Correlation Coefficient0.58Moderate positive correlation
Granger Causality TestStatistically significant (p < 0.05)Changes in interest rates cause changes in DXY

Explanation:

A Pearson correlation coefficient of 0.58 indicates a moderate positive correlation. This suggests that when the Fed raises interest rates, the DXY tends to appreciate about 58% of the time. The Granger Causality test further strengthens this association, confirming that changes in interest rates indeed precede and contribute to changes in the DXY.

5. Conclusion

Based on the analysis, we can reject the null hypothesis and accept the alternative. A statistically significant positive correlation exists between DXY and changes in the Fed's interest rate. This suggests that the Fed's monetary policy plays a significant role in influencing the DXY's movements. Higher interest rates generally attract foreign investment, increasing demand for dollars and leading to DXY appreciation. However, it's crucial to remember that correlation does not imply causation. Other factors, like global economic conditions and geopolitical events, can also influence the DXY. Nevertheless, understanding the relationship between the Fed's policy and the DXY empowers investors and businesses to make informed decisions in the complex world of foreign exchange markets.