*Reviewing the DXY US dollar index and the reasons why I don’t use it*
Welcome back to the blog! In this post I am going to revisit a topic that is very hot amongst new and, I will be honest, inexperienced traders… The DXY dollar index. The U.S Dollar has been a major topic in the last 12 months and I have written a number of posts on the subject including trade breakdowns and analysis. You can find my latest USD technical analysis vs other FX majors via the link below.
What is the U.S. Dollar Index (DXY)?
The U.S. Dollar Index (USDX, DXY, DX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies , often referred to as a basket of U.S. trade partners’ currencies. The Index goes up when the U.S. dollar gains “strength” (value) when compared to other currencies.
The DXY is a weighted index so that means that each currency used in the index does not hold an equal influence on its overall value. The weighting of each currency is listed below.
The dollar index was created in March 1973 and started out with a value of 100.00. This is important to note because when analysing the US dollars strength since creation, you can see that right now the dollar is now almost exactly the same value as when it started.
The chart below shows the DXY as at today.
As you can see on the chart, price is currently only just above 90.00, which is only 10% lower than the starting value of the DXY over 47 years ago. Record lows of 71.20 were created in 2008 on the back of the financial crisis and the all time record highs of 163.83 were reached in 1985 only 2 years before the black Monday crash in 1987.
The formula used to calculate the U.S. Dollar Index is listed below. It has only ever been altered once (in 1999), when the Euro was created and it then replaced several independent European currencies.
DXY = 50.14348112 × EURUSD-0.576 × USDJPY0.136 × GBPUSD-0.119 × USDCAD0.091 × USDSEK0.042 × USDCHF0.036
What is the U.S. Dollar Index used for?
The main use for the dollar index is to gauge the strength of the USD currency against a larger variety of other currencies. This can be useful for determining the larger term trend of the USD and using this bias to position your portfolio accordingly.
Over time it is said that commodity prices tend to fall as the dollar increases in value. This is because almost all commodities including gold, oil, wheat and even lean hogs are priced in US dollars. If the DXY is increasing in value over time then the likely hood of the commodity falling in value is increased. This is considered a negative correlation.
The chart below shows this relationship between the U.S. Dollar Index and Wheat futures.
As you can see, more often than not, when the USD gains strength and the DXY is climbing, the price of Wheat futures is falling or hits a bottom. Naturally there are also other factors on path that influence price such as demand for Wheat and supply increases/decreases but the statement is true that the value of the dollar does have an influence on commodity prices.
However, I personally have reservations against using the DXY in my own analysis and this is why.
Why I don’t use the U.S. Dollar Index.
Firstly, as I pointed out earlier, the calculations for the DXY has not been altered except for the replacement of several European currencies by the single Euro currency. This leads me to believe that the index itself is outdated.
Global markets have changed, new economies have emerged and grown and many people argue that currencies like the the Chinese Yuan should now be included in the calculation of the DXY since China is the second largest economy by GDP.
The pie chart above shows that the economies of currencies currently used in calculating the DXY are much smaller than than some economies whose currencies are not featured. China, Brazil and Mexico are all countries who trade with the U.S. yet do not feature in the “basket” of currencies within the dollar index.
My other issue with the DXY is that it is too heavily weighted to the EURUSD FX currency pair. The percentage of the U.S. Dollar Index weighting to EURUSD is 57.6% which is more than 4.2 times larger than the next currency in the basket.
This means that the U.S. Dollar Index is basically a perfect inverse of the EURUSD currency price chart and it therefore has no real meaning to me. The other currency pairs in the basket do very little to have an effect the value of the DXY compared to the Euro.
The chart above shows the DXY (blue) and EURUSD currency pair (yellow). Look at how the price of each instrument moves – they are an almost perfect mirror image of each other. If you were to calculate the correlation coefficient of the DXY and the EURUSD FX currency pair over a 20 year period I would guess that the value would be between -0.9 and -1. There is a strong negative correlation.
Remember, the U.S. Dollar Index get’s its values from the currency pairs within its basket. The FX currency pairs do not get their values from the DXY so it is a one way relationship.
As an example, let’s say you are looking at trading the AUD/USD (Australian Dollar) currency pair. You see the U.S Dollar Index falling in value so you believe that buying the AUD/USD pairing is a good bet. However, because the DXY is so strongly influenced by the Euro it is the Euro strength that is making the DXY fall in value and actually the U.S. Dollar is still stronger than the DXY makes it look.
You buy AUD/USD futures and they begin to fall in value because the U.S. Dollar is still strong. The Euro weighting means Euro strength outweighs the USD strength across other currencies.
The chart below shows this very scenario taking place.
The strong negative correlation you see on the DXY vs EURUSD chart is quickly diminished when you start looking at the relationship between the DXY and other currency pairs. This is primarily because the Euro is too strongly weighted in my opinion.
This blog post is not written to tell you not to use the U.S. Dollar Index because I am sure there are traders out there that use it in their analysis and it works for them. However, I do believe there are strong limitations to its uses and it is definitely not as good as it once was. It is outdated and the weighting used in the calculation of the DXY does need investigating.
An excellent altenrtative is the Bloomberg Dollar Index which trades under the ticker BBDXY. It is based on the same principles as the DXY so it’s value is derived from U.S dollar strength/weakness vs other currencies but the basket of currencies and their weightings are different.
The BBDXY Index data starts from Dec 31, 2004 with a base level of 1000. However, more importantly the index rebalances annually to capture annual trading flows versus the U.S. dollar as reported by the Federal Reserve and the triennial survey of most liquid currencies from the Bank of International Settlements. Each currency in the basket and their weight is determined annually based on their share of international trade and FX liquidity.
If you are interested in learning more about price correlations and how you can trade them, please check out my previous blog post on this topic. The link is below.
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