What is the US Dollar Index (USDX)?
26 July 2023
The US Dollar Index, abbreviated as USDX or DXY, is a well-known financial indicator that assesses how strong the US dollar is compared to a basket of other major currencies. It offers insightful information about the US dollar's overall performance in the foreign exchange (Forex) markets. The index is a crucial tool for traders, investors, and policymakers since it enables them to comprehend the US Dollar's place in the global financial system.
Calculation and Components
The US Dollar Index is calculated against a geometrically weighted average of six significant currencies. The six currencies are as follows, along with the index's weights assigned to each of them:
Euro (EUR) - 57.6% weight
Japanese Yen (JPY) - 13.6% weight
British Pound Sterling (GBP) - 11.9% weight
Canadian Dollar (CAD) - 9.1% weight
Swedish Krona (SEK) - 4.2% weight
Swiss Franc (CHF) - 3.6% weight
The index value is calculated using the following formula:
USDX = 50.14348112 × EURUSD^(-0.576) × USDJPY^(0.136) × GBPUSD^(-0.119) × USDCAD^(0.091) × USDSEK^(0.042) × USDCHF^(0.036)
EURUSD - Exchange rate of Euro to US Dollar
USDJPY - Exchange rate of US Dollar to Japanese Yen
GBPUSD - Exchange rate of British Pound Sterling to US Dollar
USDCAD - Exchange rate of US Dollar to Canadian Dollar
USDSEK - Exchange rate of US Dollar to Swedish Krona
USDCHF - Exchange rate of US Dollar to Swiss Franc
About the weightage of currencies in the USDX
Please note that the percentages (mentioned above) denote the ‘weightage’ of these currencies in the US Dollar Index. It is commonly known as the ‘Geometric Weighted Average.’
The weights were set in 1973 and reviewed in 1999, as the Euro replaced many European currencies.
Interpreting the US Dollar Index
The base value of the US Dollar Index is 100, which was decided upon when the index was initially created in March 1973. A score above 100 denotes a strengthening of the US dollar since the base period relative to the currency basket, while a value below 100 denotes a weakening of the dollar.
Uses and Significance
The US Dollar Index serves multiple purposes:
1) Forex Trading
It is utilized by forex traders as a reference point to gauge the strength or weakness of the US dollar against other currencies. This helps them make informed decisions regarding currency transactions and investment strategies.
2) International Trade
The USDX plays a crucial role in international trade by helping businesses assess the US Dollar purchasing power. This knowledge aids them in negotiating trade agreements effectively.
3) Central Banks and Policymakers
Central banks and policymakers closely monitor the USDX to understand how fluctuations in the US dollar impact their own economies. This information helps them formulate appropriate monetary policies.
Investors and companies use the USDX as a hedging tool against currency risk. By doing so, they safeguard their global operations and investment portfolios from adverse currency fluctuations.
Limitations of the US Dollar Index
Though USDX is followed by many economists and analysts, it has some shortcomings. Let’s discuss them briefly in this segment:
The DXY is an excellent financial flow indicator. However, as it was formed in 1973, the dynamics of international trade is changing over the years.
The index components are the significant trade partners with the US Dollar. Yet, emerging markets like China, Mexico, Brazil, India, Singapore, and more have gained significance in global trade. Thus, the USDX becomes less relevant to the practical strength of the US Dollar against these countries.
These emerging economies or developing countries gained significance in global trade and finance. So, the US Dollar Index started fading and losing its attachment with the actual strength or weakness of the US Dollar globally..
Secondly, interpreting the USDX signals needs an in-depth analysis of the interrelations between the banking and financial markets of the US, Europe, the UK, and Japan.
Many popular derivatives and funding markets in the present global scenario are blurring the currency, capital, and credit relationships between the USDX components.
Despite these limitations, USDX/DXY remains the most followed and traded index.
The USDX Peak and Trough
In 1973, when the USDX was established, the value of the US Dollar Index (USDX) was 100.00. It peaked at 164.72 in 1985 and was the lowest at 70.698 on 16 March 2008.
Are you curious about the reasons behind the fluctuations in the USDX? Let’s briefly discuss them.
The tighter monetary policy of the Fed and the expansionary fiscal policy of the then US government attracted foreign investors in the early 1980s. As a result, the US Dollar appreciated, and the USDX reached its highest value of 164.72 in 1985.
The cheaper credit and lax lending standards caused a financial crisis in the US in 2008. Affordable mortgages led to a housing bubble. Yet, as the bubble burst, banks had lended trillions of dollars in subprime mortgages. That’s why the US Dollar depreciated and the USDX reached the lowest value of 70.698 in March 2008.
The History of the US Dollar Index
It is interesting to consider some significant events in the past that resulted in the beginning of the US Dollar Index.
After World War II, the Bretton Woods Agreement marked the beginning of a collective regime for international currency exchange rates. Currencies were pegged to Gold for about three decades (from 1940s to 1970s).
The Bretton Woods Agreement was dissolved in 1971, to begin the managed float exchange rates system. Demand and supply of currencies started driving exchange rates through this era.
The US Federal Reserve (Fed) established the US Dollar Index (USDX) in March 1973. Presently, a subsidiary of the Intercontinental Exchange (ICE) - The ICE Data Indices maintains the USDX.
Why was the US Dollar Index Necessary?
In the late 1960s, the Gold standard was driving the US Dollar value. In 1967, Gold was priced at $35/oz. However, after some ups and downs, the Bretton Woods Agreement was dissolved.
Without the Gold standard in operation, the US Federal Reserve required a benchmark to assess the US Dollar value against the basket of other Forex major currencies. Therefore, the Fed worked out the USDX composition and weightage of the index components to reflect the economic significance of the US Dollar and overall global trade patterns.
The Fed established the US Dollar Index in 1973, and the components were revised in 1999 to include the Euro. As discussed earlier, the index can be more inclusive by incorporating other significant trading partners.
If the significance of cryptocurrency rises, it will be difficult to keep DXY's popularity with these flaws. A move towards a more inclusive USD index that reflects trade relations and liquidity will be welcome and will help keep USDX relevant in the future.
The article covers the meaning, components, brief history of the US Dollar Index, and why it is critical in the Forex market.
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