Making cents of the dollar index

December 24, 2015 09:00 AM

As 2016 begins, the strength and direction of the U.S. dollar will be one of the most important fundamental forces that will affect forex trading. Expectations about the changes in the value of the USD are key components of trading success. Most traders, of course, measure USD price in terms of the exchange value of the U.S. dollar vs. another currency. However, that bi-lateral valuation is only part of the picture. Accurately assessing the overall strength of the USD requires a broader perspective that is more difficult to measure. The challenge to traders continues to be how to improve their judgement in gauging dollar strength. There are several methodologies available that offer different ways to track and interpret USD valuation.

The U.S. Dollar Index (DXY) often is used by traders as a gauge of dollar sentiment. It is, however, a weighted index that seems a bit archaic. For example, the presence and weighting given the Swedish Krona (4.2%) and the Swiss Franc (3.6%) seems rather arbitrary. The weighting does not reflect the actual trade relationships of the countries. Nevertheless, the DXY does a very good job of being sensitive to daily reactions to economic data releases. However, looking at DXY alone may prove inadequate in achieving a high level of confidence in evaluating direction.   

Traders can take a second approximation of dollar strength by looking at the Bloomberg Dollar Spot Index (see “A tale of two $ indexes”). In contrast to the DXY, the BBDXY tracks 10 global currencies and their weights reflect an annual calculation of each currency’s “share of international trade and liquidity.” Note that the Chinese currency (CNH, the Offshore RMB) is included but has a weighting of only 3%. Most traders would think that the Chinese currency deserves a greater weighting. 

The challenge to the trader is to determine whether these weights are realistic or whether they undervalue or overvalue the relative impact on the USD. To further help the trader in deciding whether the dollar is strengthening or weakening, we come to an important variation on creating an index for it. The Federal Reserve Board’s Broad Dollar Index reflects a formula that considers the relationship between imports and exports and their proportion of total trade between any two countries.  The general equation used to create trade weights is: 

WJ = (imports of i/imports and exports of i) × (share of i imports from j) + (exports of i/imports and exports of i) × (overall export weight)

In this approach the Federal Reserve data weights China as 21.562% of trade weights in contrast to 3% of the Bloomberg Dollar Spot Index. Sweden gets a weighting of 0.654% in wide contrast with the DXY, which gives the Swedish currency a weighting of 4.2%.

Are these different dollar indexes useful? Let’s compare how the three different dollar indexes track. The DXY and BBDXY track very closely. A real difference in price patterns appears in the USTWBROA Index. During the volatile period following the Aug. 24 selloff, while both the DXY and the DDXY sold off, the trade-weighted index kept trending up and continued to do so. The divergence of the trade-weighted index and the other dollar indexes demonstrates that assessing the strength of the U.S. dollar requires more than a single index. While most of the time the Dollar Index remains a good quick measure of dollar sentiment, checking the pattern of the trade-weighted index could prove to give traders an edge. The trade-weighted index is likely to be more stable and balance the sensitivity of the DXY. During 2016 traders could gain an edge by watching the trade-weighted Broad Dollar Index.

About the Author

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of binarydimensions.com newsletter and can be reached at abecofnas@gmail.com.