Surely many of you have heard what an index is. This is a tool that allows you to get a complete picture of the state of the economy in a certain industry, country or even a group of countries. For the stock market, there are quite a few different indices, for example, the Dow Jones industrial index DJIA, composite index NASDAQ, Russel 2000, S&P 500, Wilshire 5000 and so on.
Before reading the article and writing your questions in the comments section, I recommend to watch this video. It’s not long but covers the biggest part of questions on the topic.
Today we will talk in more detail about the US Dollar Index (often referred to as DXY or USDX), which is widely used in Forex, and also consider its practical application in the foreign exchange market and I will share one interesting indicator with you.
Table of Contents
What is the dollar index
The US dollar index is an indicator of the strength of the US currency, followed by many market observers and analysts. It includes a basket of foreign currencies, whose value is compared with the value of the dollar. Quite simply, the dollar index shows how dollar feels against other world currencies, namely euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc. DXY is a convenient index which is used as a simple method to determine the strength and weakness of the US dollar. But its ubiquitous use masks the fact that it does not reflect the value of the dollar about a fairly large basket of other world currencies.
How the dollar index is calculated
The dollar index is a geometrically weighted index of the main (above listed) trading partners of the United States. The structure of the dollar index is strongly biased towards the euro and European countries that have not yet joined the common European market. Weighted components of the dollar index: euro (57.5%), the Japanese yen (13.6%), the British pound sterling (11.9%), the Canadian dollar (9.1%), the Swedish krona (4.2%) and the Swiss franc (3,6%). Due to this composition of the DXY index, it is also called the “anti-European” index.
So, how many countries are included in the index? If you think there are six, then you are mistaken. There are many more. The fact is that the euro is the official currency in 19 countries of the Eurozone: Austria, Belgium, Germany, Greece, Ireland, Spain, Italy, Cyprus, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, Finland, France, Estonia. The euro is also the national currency of another 9 states, 7 of which are located in Europe.
However, unlike the Eurozone participants, these countries can not influence the monetary policy of the European Central Bank and send their representatives to its governing bodies. These countries are not included in the dollar index. Add another 5 countries to it: Japan, Britain, Canada, Sweden and Switzerland – and you will get almost the entire civilized world. Indeed, China is missing, but yuan is a specific currency, it has not become a world reserve, it has a special attitude towards it. The countries in the index are not equal in their economic possibilities, therefore each of them in the index is allocated only its share, which becomes more clear when looking at the formula for calculating the index:
DXY = 50.14348112 × EUR/USD^(-0.576) × USD/JPY^(0.136) × GBP/USD^(-0.119) × USD/CAD^(0.091) × USD/SEK^(0.042) × USD/CHF^(0.036)
The first coefficient in the formula gives the value of the index to 100 on the date of the beginning of the countdown – March 1973, when the main currencies began to be freely quoted relative to each other.
Disadvantages of the dollar index
Because the dollar index is strongly shifted towards European currencies, it significantly lowers the share of the dollar of Canada, which is a major partner of the United States. Also, this index completely ignores the currencies of the Asia-Pacific region, including Korea, Australia, Taiwan and, more importantly, China. But even if someone tried to include the Chinese yuan in the calculation of the dollar index, it would be very difficult and not entirely correct, since China has tied the value of its currency to the US dollar.
Despite some shortcomings, the DXY index serves as a reliable indicator of the strength and weakness of the US dollar and it can be used as such if one remembers that it can be distorted during significant fluctuations of the single European currency.
History of the dollar index
The dollar index (DXY) was created by JP Morgan in 1973 and since that time it was updated only once when the European single currency was introduced in Europe.
The base value of the USDX index was the level of 100,00. For example, the level of 107,50 means that the value of the dollar increased by 7,5 percent, relative to the base value. March 1973 was chosen as the base period since from that time the largest trading countries introduced floating exchange rates. This agreement was reached at the conference of the Smithsonian Institution in Washington. The Smithsonian agreement replaced the failed policy of fixed rates, set about 25 years earlier in Bretton Woods.
Since 1973, the index was trading at a maximum in the area of 160,00, and on 13 March 2008, a new lower level was set at 71,99. The index is updated 24 hours a day, 7 days a week. Just like the Dow Jones (DJI) index is the main indicator of the US stock market, the USDX index gives a general idea of the international value of the US dollar.
Here is what its schedule looks like:
If the dollar index is so inaccurate, why does everyone pay so much attention to it?
Although there are more accurate ways to assess the US dollar, absolute accuracy is not always important for the indicator. Many traders and financial companies, for sure, have their indicators, which they use to track the value of the dollar, but for comparison it is always very convenient to use a common index. Most of the time, the dollar index also closely correlates with the trade-weighted index (TWDI – Trade-Weighted Dollar Index), which is used by the US Federal Reserve.
It was created to more accurately reflect the value of the dollar about other national currencies, taking into account the competitiveness of American goods and services. The relative strength or weakness of the US dollar movement reflects huge flows of money. The growth of the US dollar index by 10% is equivalent to a nominal fall in the value of world wealth by more than 1 trillion dollars. Movement of such magnitude does not occur in a vacuum, and the relative weakness of the dollar index reflects the corresponding weakness of the trade-weighted index.
The index is quite new, it appeared in 1998. There are already a lot more currencies in it (there is yuan, and even ruble), and their share in July 2017 looks like this:
You can always get more recent data on the official site of the Federal Reserve.
By the way, there you can get hold of the history of quotations for the period of D1 dollars to major world currencies since 1971.
In general, if you look briefly at the TWDI chart, it is almost indistinguishable from DXY:
Nevertheless, with a closer look, the differences are visible. The main difference between the two indices of the dollar – their basket includes a different number of currencies. In the case of the index from the Fed, it presents a lot more countries and far from all of them are industrial and financial leaders – there are many developing. So the TWDI index from the Fed is a more global reflection of the value of the dollar against world currencies. At the same time, a share of currencies is based on data on the trade balance, which is updated annually.
The Dollar Smile Theory
The dollar is a very interesting currency, it can be strengthened both in bad and in good economic conditions. As a result, one of the employees of Morgan Stanley somehow came up with a fundamental theory that allows explaining this phenomenon. It was Stephen Jen, an economist, and currency analyst. His theory is called The Dollar Smile Theory. The essence of the theory is that the US dollar in all its diversity always adheres to only three scenarios.
The first part of the smile implies a situation where investors are looking for a “haven” for their funds, stored in dollars and yen. Since investors believe that the global economy is hindering, they are slow to acquire risky assets and prefer to invest in less risky dollar, even if the US economy does not show a particular success.
The second scenario is when the dollar drops sharply, updating the minimum values. This is the bottom part of the smile, which says that the US economy is weak, just like its national currency. In this scenario, interest rates are often reduced, which can also affect the cheapening of the dollar. As a result, the market gets rid of the dollar, and the smile becomes wider.
And so we go on to the third scenario. The dollar is again loved and respected due to economic growth in the US. Optimism is increasing, traders are beginning to buy dollar assets, US GDP is growing, and the growth of key rates is expected.
A clear example of this theory is the crisis of 2007. In 2008, at the height of the economic crisis, the dollar sharply began to strengthen: investors fled from the global fire to a strong currency, launching the first scenario. Then, in March 2009, investors switched to higher-yielding currencies, and the dollar showed an impressive drop. This was the second scenario, after which the third one started: the new growth of the dollar, which lasted until the summer of 2010, after which the cycle repeats.
This theory is just a particular example of how the economy of any country has a cyclic nature.
Well, it is time for us to discuss the concrete application of the dollar index in trading.
Historical data and forecasts
Since the beginning of 2017 and to date, the dollar index has fallen from 103,26 points to 95,72 points, showing a decrease of 7,54 points.
As you can see on the graph of the DXY index of period D1, now it is at the lower boundary of the channel, which is located since 2015. At the same time, in early 2017, a breakdown of the channel was undertaken, which was not crowned with success. I assume that the following behavior will be approximately the following:
Pretty soon it will be possible to expect the strengthening of the dollar at least to the upper boundary of the channel, and perhaps its breakdown. Unless, of course, the lower limit is broken. In any case, we are very close to the key point, the passage of which will serve as an excellent hint for further action.
That rapid growth of the index, which dates back to mid-2014, clearly took a long-term pause, but a new serious trend is only a matter of time. And at the moment, when we are just at the key point, this question becomes very urgent, because it is in the coming months, weeks, and maybe even days, that we can quite accurately catch the moment of the birth of this very long-term trend.
But, of course, serious long-term traders never rely on technical analysis alone. It serves only as a trigger for the trade: it is important to pull it at the right time. Nevertheless, most often fundamental analysis determines in what direction to shoot. And several fundamental prerequisites are also in favor of my forecast:
- First, it is the beginning of the cycle of raising the rates of the US Federal Reserve against the protracted soft monetary policies of the ECB and the Bank of Japan;
- Secondly, it is a potential negative effect (for the pound) on the UK’s exit from the European Union.
Earlier, a strong dollar hurt commodity assets, so the resumption of negative impact on oil quotes or, for example, copper – with the growth of the US dollar should not be ruled out. The dynamics of US Treasury bonds can be called the intrigue of the year, whether the decline in securities will continue or not.
Now that we have identified the main macroeconomic drivers that support our forecast, let’s take a look at the monthly index chart for completeness:
In my view, the downtrend, which lasted from 2002, ended after the breakdown of the triangle in the second half of 2014. From that moment we observed a strong uptrend, which was replaced by a lateral range of consolidation, in case of breakdown of the upper limit of which the uptrend is likely to continue.
Application in trading
It is hard to say why JP Morgan created this index and why it became so popular. A very strange thing is that this index can not be traded. There is no market on which you could buy the dollar index. The only tools which take into account the movement of DXY, are futures and options on this index, which are traded on the Exchange InterContinental Exchange.
The chart of the dollar index is easy to open. Most often in the trading terminal it is designated as DXY or as USDX. As has been mentioned above, you can see the updates of the index on the same schedule as the currency rate updates, that is, 24 hours a day from Monday to Friday.
The dollar index can be used to analyze currency pairs of the Forex market, just as stock market investors use stock indexes as a base contract to determine the general direction of the trend in the market. If you trade currency pairs which have a currency of USD in their quotation, the dollar index will give an idea of the relative strength of the dollar concerning currency pairs such as EURUSD, GBPUSD, USDCHF, etc. and in case of uncertainty of the forecast will give a clearer picture of the market. We can safely say that USDX has a correlation with the above-mentioned currency pairs and this indicator can be used by the trader as an additional indicator in the analysis of the market. In the figure below, using the tradingview service, I have derived a correlation between the dollar index and the major currency pairs that make up the index.
As can be seen from the chart, the correlation is indeed quite high.
You can observe the dollar index in a separate window of the trading terminal or the browser window on the site, but for convenience, an indicator is created that shows the USDX chart window under the schedule of the selected currency pair.
Many people keep an eye on DXY for not only coincidence but also differences with the EURUSD pair since such a discrepancy can be considered a divergence.
If DXY shows increased volatility, it will find its reflection in other index currencies, the breakdown of the support/resistance level on one chart corresponds to a breakdown on others.
Let’s not forget where exactly the dollar is in your currency pair, it can be either a base currency or a quoted currency.
If DXY strengthens and goes up (and therefore, the dollar strengthens), then the EURUSD chart will go down.
On the contrary, for the pair USDCHF, strengthening the dollar means moving the chart upward. If the dollar is the base currency (the first in the currency pair), then the dollar index and the currency pair will go in one direction. If the dollar is a quoted currency, then the index and the currency chart will go in different directions. Quite often, movement along the index anticipates movements in the main currency pairs.
If, for example, a candlestick is on a bearish index, then on a EURUSD pair it should be bullish. If this is not the case, then we have a divergence and will open in the purchase of EURUSD. We will close the position in two days. We also use the easiest trailing stop and do not forget to set the stop loss levels and take profit.
Since the dollar index reflects the value of the basket of currencies relative to the dollar, it gives a clearer idea of the strength or weakness of the dollar than when you look at one currency pair like EURUSD. Many experienced traders turn to the US dollar index before trading the currency pair with the dollar and to avoid trading against the trend of the index.
The dollar index is a macroeconomic indicator. It is used to assess the global state of the American currency on the older timeframes. It is used either as an addition to the fundamental analysis or to search for discrepancies between the index and EURUSD at D1 and above. Studying the inflation and economic indicators of the US, the index will add one more variable to the equation and allow assessing the global outlook for the US currency. That is why he is a frequent guest on the screens of professional currency traders and analysts.
The dollar index is influenced by common factors that affect currencies, such as:
- fiscal and monetary factors;
- interest rates;
- foreign trade.
That is why the analysis of the dollar index can serve you as an excellent foundation for developing your long-term trading strategy.