What is the DXY dollar index?
The DXY is an indicator that many market observers and commentators refer to and quote from. So what is the DXY or US dollar index?
The DXY is a geometrically weighted index of some of the major trading partners of the United States. The composition of the DXY index is heavily weighted towards the Euro and European countries that have not joined the European Common Market. The components of the DXY index are (by weighting): Euro (57.6%), Japanese Yen (13.6%), British Pound Sterling (11.9%), Canadian Dollar (9.1%), Swedish Krona ( 4.2%) and Swiss Franc (3.6%). Due to the composition of the DXY, it is sometimes referred to as the Anti-Euro Index.
The DXY is a convenient index to use as a simple method of referencing the strength and weakness of the US dollar (USD). But its ubiquity belies the fact that it does not reflect the value of the dollar against a sufficiently large basket of currencies. The DXY was created by JP Morgan in 1973 and has only been updated once, for the introduction of the euro.
The DXY is heavily weighted towards European currencies, is underweight the Canadian dollar, as a share of US trade, and largely ignores major Asia-Pacific trading partners including Korea, Australia, Taiwan and necessarily China. Even if one were interested in including the Chinese Renminbi (Yuan), it would be difficult and of questionable informational value to include the Renminbi because China keeps its currency pegged in a range that is based on the dollar.
A more accurate basket of currencies to track the relative value of the USD would be to value the dollar against the major trading partners of the US. The top 6 trading partners of the US, from highest to lowest, are: Canada, China, Mexico, Japan, Germany and the United Kingdom. It is hard to say why JP Morgan created this index and how it became so important. One strange thing about this index is that you cannot trade it. There is no market where you can go and buy the DXY. The closest you can get are futures and options contracts traded on the InterContinental Exchange (ICE).
If it’s so inaccurate, why is it cited so much? While there are more accurate ways to compare the USD, absolute precision isn’t always important for an indicator. Many traders and institutions likely have their own indices that they use to track the USD, but for comparison’s sake, it’s very convenient to have a common index. The DXY is also highly correlated with a trade weighted index most of the time. Movements of relative strength or weakness of the USD represent huge flows of money. As I’ve previously written, the recent +10% move in the DXY represents over $1 trillion of nominal wealth destruction. Moves of this magnitude do not occur in a vacuum and the relative weakness of the DXY is mirrored by corresponding weakness in the Trade Weighted Index.
While there are shortcomings, the DXY serves as a reliable indicator of USD strength and weakness and can be used as such, as long as it is noted that it will occasionally be skewed if there are large currency moves in the Euro.