The US Dollar Index (USDX, also abbreviated to DXY) is one of the most well-known and widely observed indices on the global trading markets. It is designed to track the changing value of the US dollar (USD) — the world’s primary reserve currency and the most frequently used in international trade — against six other prominent currencies.
Due to its weighting system and sensitivity to world events and economic data, the USDX is generally regarded by traders and economists alike to be a fair assessment of the US dollar’s value on the global stage — and indirectly, a barometer for the strength of the US economy as a whole.
Let’s take a look at how it works, and why it remains a useful tool for traders around the world, in more detail:
How Does the US Dollar Index Work?
The USDX was first introduced after the Bretton Woods Agreement — an arrangement devised in 1944 that formalised global exchange rates relative to the gold-backed USD — was dissolved in March 1973 to make way for a more free-floating exchange rate system.
Technically a weighted geometric mean of the US dollar’s value relative to other major currencies, the index is overseen by Intercontinental Exchange (ICE) and takes the form of a numerical figure calculated to three decimal places, which is generated in real-time approximately every 15 seconds.
On the day the index was first published, it was given a reading of 100 that now acts as a baseline figure against which all subsequent performance is now measured. For example, a USDX figure of 93.500 would indicate the dollar’s value has fallen 6.5% since the index was established, whereas a reading of 112.750 would mark a growth of 12.75% in the dollar’s value (relative to the six currencies measured) over that same timeframe.
The highest ever USDX reading, 164.72, was recorded in February 1985, while its historical low of 70.698 was reached around the time of the Global Financial Crisis (GFC) in March 2008. The index is multifaceted in nature and is influenced by a variety of factors such as economic growth, recessions, inflation/deflation — both in the US and abroad — as well as knock-on effects from political events.
Further reading: https://www.babypips.com/learn/forex/using-the-usdx-for-forex
Which Currencies Make Up the US Dollar Index?
The US Dollar Index currently comprises a basket of six major world currencies, namely the euro (EUR), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Japanese yen (JPY) and Swedish krona (SEK).
The above list has, so far, only been updated once since the index’s inception; this occurred in 1999 with the addition of the euro following its adoption by much of continental Europe, replacing five European currencies previously included in the USDX — including the French franc (F), German deutschemark (DEM) and Spanish peseta (ESP).
As such, it’s worth bearing in mind that despite only including six currencies, the index actually tracks the dollar’s performance in 24 different countries, with the euro representing 19 of them!
How are the Currencies in the USDX Weighted?
Because each of these regions are different in size and influence, each constituent currency is given its own weighting to ensure smaller countries don’t skew the data out of proportion.
At the time of writing, these weightings are as follows:
· Euro: 57.6%
· Japanese yen: 13.6%
· British pound: 11.9%
· Canadian dollar: 9.1%
· Swedish krona: 4.2%
· Swiss franc: 3.6%
Interestingly, some analysts have argued that — due to the ever-changing geopolitical landscape — the USDX basket is likely to be updated in the coming years to include emerging global powers and US trading partners such as China (via the Chinese yuan, CNY) and Mexico (via the Mexican peso, MXN).
Further reading: https://www.dailyfx.com/us-dollar-index/what-is-us-dollar-index.html
What is the ‘Dollar Smile’ Theory?
Devised by former IMF and Morgan Stanley economist Stephen Jen, the ‘dollar smile’ theory is an interesting way to visualise the way the USDX typically behaves in certain situations.
Essentially, because of the USD’s prominence in global trade and its status as the world’s premier reserve currency, the US dollar often stands to gain momentum in the face of both optimistic and pessimistic market sentiments.
This idea gets its name from the fact that a visual representation shows the value going upwards at either extremity:
In two of the three scenarios above, the US dollar reacts positively; this is because there are two market forces at work simultaneously — one being domestic and the other being international.
In the domestic scenario, the USD behaves just like any other currency, i.e. when the US economy is booming, investors flock to place their capital in American banks and businesses, leading to an increase in value for the dollar.
However, the USD’s reputation as a stable, safe-haven currency means that foreign investors often also choose to store their wealth in the dollar at times of economic upheaval — as opposed to more riskier, volatile currencies — leading to this seemingly paradoxical, horseshoe theory type of situation.
Indeed, the dollar smile often works in cycles: the USD rises due to risk aversion, the US economy stalls leading to a weakened USD, which is eventually followed by a pick-up in momentum and a strengthened USD once more.
The dollar smile theory is a useful one as it enables traders to recognise the sentiment changes that trigger market shifts and helps them to anticipate where the market may be heading in the near future.
Further reading: https://www.freeforexcoach.com/the-dollar-strength-in-any-condition-dollar-smile/
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