The DXY is an indicator that is referenced and cited by many market watchers and commentators. 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 constituents 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 hides 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.
DXY is heavily weighted towards European currencies, is underweight the Canadian dollar as a proportion of US trade, and largely ignores major Asia-Pacific trading partners including Korea, Australia, Taiwan and necessarily Chinese. 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 to a range 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 major US trading partners. The top 6 US trading partners, from largest to smallest, are: Canada, China, Mexico, Japan, Germany and the United Kingdom. It is difficult 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 quoted so much? While there are more precise ways to compare the USD, absolute accuracy is not always important for an indicator. It is likely that many traders and institutions have their own indices that they use to track the USD, but for the sake of comparison it is very convenient to have a common index. The DXY is also highly correlated to a trade-weighted index most of the time. The relative strength or weakness movements of the USD represent huge flows of money. As I have written before, DXY’s recent +10% move represents over $1 trillion of nominal wealth destruction. Moves of this magnitude do not happen in a vacuum and the relative weakness of the DXY is reflected in the 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 kept in mind that it will occasionally be biased if there are large currency moves in the Euro.
