The US Dollar Index, also known as the DXY Index or USDX, is the main instrument used to assess at which level the US Dollar is trading compared to other currencies. Let us analyze which currencies are used to analyze the strength of the US Dollar, their weighs and how to use such an important benchmark.
Content
- What is the DXY or Dollar Index and why does it exist?
- Weightings
- What is the purpose of the DXY index?
- Historical record levels
- Flaws of the DXY index
What is the DXY or Dollar Index and why does it exist?
The DXY Index, officially known as the U.S. Dollar Index, measures the level at which the U.S. dollar trades against a basket of foreign currencies. Consequently, it gives us an idea of whether the dollar strengthens or weakens against other major currencies.
Until 1971, the world was on a gold standard through the US dollar. This meant that the value of the US currency was pegged to gold, and the value of all other major currencies was pegged to the dollar. By doing this, though indirectly, the value of most major currencies was pegged to gold. That system was known as Bretton Woods.
Back then an ounce of gold was valued at $35. At the same time the value of the German Mark, the German currency, was fixed at around 4 Marks for every US Dollar throughout the 1960s. Effectively that meant that an ounce of gold was valued at about 140 Marks.
However, US President Richard Nixon suspended the convertibility of the dollar into gold in August 1971, putting an end to the gold standard. From that moment on, all currencies became fiat, that is, without intrinsic value. Their value is purely based on trust. They only have value because we expect other people to also think they have value.
As a result, the value of all currencies started to fluctuate. Because the price of once currency is always measured in terms of another currency, i.e. How many US Dollars is worth a British Pound or how many Japanese Yen is a US Dollar worth, people realized having a reliable way to measure those movements in the foreign currency market were.
This is because just focusing on the value of a certain exchange rate, like the US Dollar against the Japanese Yen, does not tell us the whole story. That rate may be going up because the dollar is indeed strengthening, or simply because the Yen is weakening.
Because of that, many investors started to wonder if it would be possible to measure the strength of the US Dollar without having to rely on such an imperfect instrument as a single currency pair.
In 1973, and with that purpose in mind, the Federal Reserve introduced the US Dollar index, famous nowadays by its acronym DXY. It measured the value of the dollar against a basket of 10 foreign currencies: the Japanese Yen, the Canadian dollar, the German Mark, the Pound Sterling, the French Franc, the Italian Lira, the Dutch Guilder, the Belgian Franc, the Swiss Franc and the Swedish Krona.
The initial value of the dollar index was set at 100.
Several years later, in 1985, ICE (Intercontinental Exchange), a company in charge of several stock exchanges including the NYSE, introduced a financial derivative contract linked to the value of the DXY index. It was a futures contract and became very successful. ICE has been in charge of calculating the value of the US Dollar Index ever since.
In 1999, due to the imminent introduction of the Euro in the financial markets, the exchange rate between the Euro and many European currencies was fixed. Effectively, those currencies stopped fluctuating by themselves. Their value became a derivative of the Euro’s, even though the Euro did not come into circulation until 2022.
For that very reason, since 1999 the US Dollar index measures the value of the US Dollar against only 6 currencies. The Euro replaced the German Mark, the French Franc, the Italian Lira, the Dutch Guilder and the Belgian Franc, taking up the entire weight that had once been assigned to all these currencies.
Apart from the Euro, the Japanese Yen, the Pound Sterling, the Canadian Dollar, the Swiss Franc and the Swedish Krona were the other currencies included in the calculation of the DXY.
Let us take a closer look at the effective composition of the Dollar index.
Weightings
The index has only been updated once in history, in 1999, when 5 European currencies were replaced by the Euro. The weighting of each of the currencies within the index has never been adjusted. In this regard, the DXY dollar index has remained very stable in terms of its composition.
Currently, the index measures the exchange rate of the US dollar with that of 6 foreign currencies according to the following weights:
Nowadays the DXY dollar index is highly dominated by the exchange rate between the Euro and the US Dollar. The common European currency makes up more than half of the index. For this reason, the monetary policy of the euro zone is a major driver of the level at which the index is trading.
Originally and until the introduction of the Euro, the DXY dollar index was composed of 10 currencies with the following weightings:
As we can see, up until 1999, the German mark was the currency with the highest weighting.
The exact formula of the DXY dollar index is as follows:
USDX = 50.14348112 × EURUSD -0.576 × USDJPY 0.136 × GBPUSD -0.119 × USDCAD 0.091 × USDSEK 0.042 × USDCHF 0.036
Its value is updated in real time by ICE. If you want to know more details about the calculations, check out their website.
What is the purpose of the DXY index?
The DXY dollar index is a crucial benchmark for analyzing the value of the US dollar against other fiat currencies. It can be used to assess the global macroeconomic situation, as well as the level of economic and financial uncertainty in the world. Let us talk about that in more detail.
We have already discussed that the index was launched in 1973 with an initial value of 100. As a result, any value above 100 means that the dollar is trading stronger against other currencies than in 1973. Conversely, if the index is below 100, it means the dollar is weaker.
Looking at the absolute level of the index as well as the trend it is in, is key to understanding the macroeconomic context of the moment. For example, the highest levels of the DXY index were seen in the mid-1980s. It was a time marked by high interest rates in the United States and a very strong economic crisis in Latin America.
By contrast, the era before and after the financial crisis that began in 2008 saw very low levels in the DXY index. Those years were marked by lower interest rates in the United States than in the rest of the world, and an unprecedented monetary expansion after the onset of the crisis.
At the same time, if we want to analyze the level of uncertainty in the financial markets, we will look at the movements of the index in the short term. Why? Because in times of stress in the markets, investors often sell their risky investments, such as stocks and foreign corporate bonds, to put their money in safe haven assets, such as the dollar.
For example, throughout the month of March 2020, the US Dollar index rose 8% in a matter of two weeks. An 8% movement in the forex market, in such a short period of time, is extreme. But panic was at peak levels and markets were in free fall, hence investors were running for a safe haven.
Historical record levels
The highest level recorded in the DXY index was on March 5, 1985, when it stood at 163.83. It was during Ronald Reagan’s presidency. The United States had begun raising interest rates in the early 1080s to combat inflation and defend the value of the dollar, which was losing all its credibility in the late 1970s, both in international markets and within the United States.
It should be noted that the index closed the year 1987 below 86, a fall of almost 50% in less than 3 years. That was mainly triggered by the Plaza Accord agreement, when a number of countries gave their commitment to devalue the dollar in favor of the Japanese Yen and the German Mark.
The lowest level ever seen in the DXY index was on March 16, 2008, when it stood at 70.698. Rumors about an impending economic crisis in the United States and problems in its banking system weighted on the American currency. Also, the perception at the time that the situation in Europe was much better. It was not.
Flaws of the DXY index
While the DXY index is widely used to analyze the value of the U.S. currency in financial markets, there are two main criticisms that come up on a regular basis:
It is an outdated index
As we have previously seen, the index was introduced in 1973 and has never been updated, neither in its composition nor in the weighting assigned to the currencies within the index, beyond replacing certain European currencies with the Euro in 1999.
The initial composition was based on U.S. trade relations in the early 1970s. However, things have changed dramatically since then. As a result, some of America’s major trading partners are not represented.
If we look at the 10 countries with the most trade with the United States, we will find China (first in the ranking), Mexico (third), South Korea (sixth) and India (ninth). None of those currencies are represented in the index.
The value of the dollar is always against other currencies
The other criticism commonly made about the US dollar index is that it only measures the value of the US dollar against a basket of fiat currencies. Because all currencies are continuously debased due to inflation, the DXY tells us nothing about the value of the dollar itself, only about its value relative to other currencies.
In this regard, if we wanted to measure the value of the dollar over time, it would be more useful to look at the price of gold against the dollar, or the overall inflation that has taken place in the United States.
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