When we talk about the dollar, we talk about the U.S. Dollar Index.
There’s almost no escaping it. The U.S. Dollar Index is the standard measure for the greenback, much as the Dow or the S&P is the standard measure for the stock market.
But what happens when an index gets outdated?
As The Wall Street Journal points out, the U.S. Dollar Index “hasn’t been adjusted in 12 years.” And the weightings in the index are strange. The numbers may fluctuate a little, but the following breakdown is roughly on point:
- Euro 58.6%
- Japanese yen 12.6%
- Pound sterling 11.9%
- Canadian dollar 9.1%
- Swedish krona 4.2%
- Swiss franc 3.6%
Immediate questions spring to mind with that mix. Where is the Australian dollar? Or the Chinese yuan? And the Swedish krona still has a stronger weighting than the Swiss franc? Really?
The biggest concern of all is that the U.S. Dollar Index has become a giant inverse-euro bet.
With such an overwhelming weighting towards euros (nearly 59%), the fortunes of Europe have a hugely outsized impact on the dollar. What’s more, if you chose to lump in the British pound and Swedish krona, nearly 75% of the index could be considered Europe-based.
“The U.S. Dollar Index was created by the Federal Reserve in 1973,” the WSJ reports, “and was meant to be a trade-weighted average of the dollar’s value as it freely floated against other currencies.”
While the index originally had a basket of 10 currencies, that number was dropped down to six with the introduction of the euro — and hasn’t changed since.
The U.S. Dollar Index is certainly still tradable. It’s the underlying basis for dollar-index futures, and thus also for the PowerShares dollar bullish (NYSE:UUP) and bearish ETFs (NYSE:UDN).
But it’s helpful to remember that, in terms of the question “What’s happening to the dollar?” the index does not necessarily give a full or accurate picture.
Also like the Dow and S&P, the U.S. Dollar Index is liquid, popular and deeply entrenched in terms of various trading vehicles tied to it. There is a “network effect” at work — the more traders and investors who pay attention to the index and use it as a proxy, the stronger its influence becomes.
The real acid test of the U.S. Dollar Index may come alongside seismic currency shifts in Asia. If the Japanese yen succumbs to debt crisis, for example, or the Chinese yuan moves to a new level of convertibility, the outdated composition of the index may have to be addressed.
In the meantime, it’s easy enough to get a rundown of “what’s happening with the dollar” through a handful of readily available instruments.
Here is a quick reference list:
- euro currency (NYSE:FXE)
- Japanese yen (NYSE:FXY)
- Canadian dollar (NYSE:FXC)
- Australian dollar (NYSE:FXA)
- British pound (NYSE:FXB)
- Swiss franc (NYSE:FXF)
- Mexican peso (NYSE:FXM)
- Swedish krona (NYSE:FXS)
- Chinese yuan (NYSE:CYB)
- Gold (NYSE:GLD)
All of the above are exchange-traded funds, or ETFs — some of them much more liquid than others. Each provides a snapshot of a single currency as traded against the dollar.
When one wants to “see how the dollar is doing,” it may make sense to quickly scroll through long-term charts of the above — if not the currency futures or spot forex pairs — as opposed to quickly glancing at the U.S. Dollar Index. If the euro and $USD are in gridlock but other important movements are afoot — like major moves in the franc, yen or Aussie dollar, for example — a scan of individual forex pairs will show it.
You may notice that the final entry, SPDR Gold ETF (NYSE:GLD), does not fit in with all the rest. Adding gold is somewhat tongue in cheek, but also a fair addition to the list, given the yellow metal’s longstanding role as a “neutral currency.”
So we’ll keep following the U.S. Dollar Index and considering the merits of the attached trading vehicles… but with recognition that it’s a bigger and more diverse world now.
Justice Litle is the Editorial Director of Taipan Publishing Group, Editor of Justice Litle’s Macro Trader and Managing Editor of the free financial market news e-letter Taipan Daily. Justice began his career by pursuing a Ph.D. in literature and philosophy at Oxford University in England, and continued his education at Pulacki University in Olomouc, Czech Republic, and Macquarie University in Sydney, Australia.
Article brought to you by Taipan Publishing Group, www.taipanpublishinggroup.com.