Why the USD Index Needs an Overhaul

09/02/2011 7:00 am EST

Focus: FOREX

Justice Litle

Editor, Outstanding Investments

The US Dollar Index hasn’t been updated in years, and other vehicles give a broader perspective of how the greenback is doing.

When we talk about the dollar, we talk about the US Dollar Index.

There’s almost no escaping it. The US 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But what happens when an index gets outdated?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 US 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 US 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 US 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 ten currencies, that number was dropped down to six with the introduction of the euro—and hasn’t changed since.

chart
Click to Enlarge

The US Dollar Index is certainly still tradable. It’s the underlying basis for dollar-index futures, and thus also for the PowerShares dollar bullish and bearish ETFs (UUP and UDN respectively).

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.

Sort of like the Dow Jones Industrial Average without Apple (AAPL) or Google (GOOG). Can we really say that such a limited slice represents the true market?

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Also, like the Dow and S&P, the US 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 US Dollar Index may come alongside seismic currency shifts in Asia. If the Japanese yen succumbs to a 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 (FXE)
  • Japanese yen (FXY)
  • Canadian dollar (FXC)
  • Australian dollar (FXA)
  • British pound (FXB)
  • Swiss franc (FXF)
  • Mexican peso (FXM)
  • Swedish krona (FXS)
  • Chinese yuan (CYB)
  • Gold (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 US 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, 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 US 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 editor of Taipan Publishing Group.

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