If U.S. stocks have an index, so does the U.S. dollar! Read up on the dollar index and learn how you can use it in your trading!
What is the US Dollar Index (USDX)?
If you’ve traded stocks, you’re probably familiar with all the indices available such as the Dow Jones Industrial Average (DJIA), NASDAQ Composite Index, Russell 2000, S&P 500, Wilshire 5000, and the Nimbus 2001.
Oh wait, that last one is actually Harry Potter’s broomstick. Well if U.S. stocks have an index, the U.S. dollar can’t be outdone.
For currency traders, we have the U.S. Dollar Index (USDX).
The U.S. Dollar Index consists of a geometric weighted average of a basket of foreign currencies against the dollar.
Okay before you fall asleep after that super geeky definition, let’s break it down.
It’s very similar to how the stock indices work in that it provides a general indication of the value of a basket of securities. Of course, the “securities” we’re talking about here are other major world currencies.
The US Dollar Index Currency Basket
The U.S. Dollar Index consists of SIX foreign currencies. They are the:
- Euro (EUR)
- Yen (JPY)
- Pound (GBP)
- Canadian dollar (CAD)
- Krona (SEK)
- Franc (CHF)
Here’s a trick question. If the index is made up of 6 currencies, how many countries are included?
If you answered “6”, you’re wrong.
If you answered “24”, you’re a genius!
There are 24 countries total, because there are 19 members of the European Union that have adopted the euro as their sole currency, plus the other five countries (Japan, Great Britain, Canada, Sweden, and Switzerland) and their accompanying currencies.
It’s obvious that 24 countries make up a small portion of the world but many other currencies follow the U.S. Dollar index very closely.
This makes the USDX a pretty good tool for measuring the U.S. dollar’s global strength.
US Dollar Index (USDX) Components
Now that we know what the basket of currencies is composed of, let’s get back to that “geometric weighted average” part.
Because not every country is the same size, it’s only fair that each is given appropriate weights when calculating the U.S. dollar index. Check out the current weights:
With its 19 countries, euros make up a big chunk of the U.S. Dollar Index.
The next highest is the Japanese yen, which would make sense since Japan has one of the biggest economies in the world. The other four make up less than 30 percent of the USDX.
The other four make up less than 30 percent of the USDX. Here’s a question: When the euro falls, which way does the U.S. Dollar Index move?
The euro makes up such a huge portion of the U.S. Dollar Index, we might as well call this index the “Anti-Euro Index“.
Because the USDX is so heavily influenced by the euro, people have looked for a more “balanced” dollar index.
More on that later though. First, let’s go to the charts!
How to Read the US Dollar Index
Just like any currency pair, the US Dollar Index (USDX) even has its own chart.
Holler at the U.S. Dollar Index:
First, notice that the index is calculated 24 hours a day, five days a week.
Also, the US Dollar Index (USDX) measures the dollar’s general value relative to a base of 100.000. Huh?!?
Okay. For example, the current reading says 86.212.
This means that the dollar has fallen 13.79% since the start of the index. (86.212 – 100.000).
If the reading was 120.650, it means the dollar’s value has risen 20.65% since the start of the index. (120.650 – 100.00)
The start of the US Dollar Index is March 1973. This is when the world’s biggest nations met in Washington D.C. and all agreed to allow their currencies to float freely against each.
The start of the index is also known as the “base period“.
The U.S. Dollar Index Formula
This is strictly for the grown and geeky. Here is the formula for calculating USDX:
USDX = 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)
Trade-Weighted Dollar Index
There is also another kind of dollar index used by the Federal Reserve. It is called the “trade-weighted U.S. dollar index“.
The Fed wanted to create an index that could more accurately reflect the dollar’s value against foreign currencies based on how competitive U.S. goods are compared to goods from other countries. It was formed in 1998 in order to keep up-to-date with U.S. trade.
The Trade-Weighted U.S. Dollar Index
From strongest to weakest, here is the current weighting (in percentage) of the index:
*Weights as of February 12, 2017
The main difference between the USDX and the trade-weighted U.S. dollar index is the basket of currencies used and their relative weights. The trade-weighted index includes countries from all over the world, including some developing countries.
Given how global trade is developing, this index is probably a better reflection of the dollar’s value across the globe.
The weights are based on annual trade data.
Weights for the broad index can be found at http://www.federalreserve.gov/releases/H10/Weights.
If you’d like to see historical data, check out http://www.federalreserve.gov/releases/h10/Summary/.
How to Use the USDX for forex trading
I bet you’re wondering, “How do I use this USDX in my trading arsenal?”
Well, hold your trigger finger and you’ll soon find out! We all know that most of the widely traded currency pairs include the U.S. dollar.
If you don’t know, some that include the U.S. dollar are EUR/USD, GBP/USD, USD/CHF, USD/JPY, and USD/CAD. What does this mean? If you trade any of these pairs, the USDX can be the next best thing to sliced bread (or hamburger on a bun… or chocolate ice cream).
If you don’t, the USDX will still give you an idea of the relative strength of the U.S. dollar around the world.
In fact, when the market outlook for the U.S. dollar is unclear, more often times than not, the USDX provides a better picture.
In the wide world of forex, the USDX can be used as an indicator of the U.S. dollar’s strength. Because the USDX is comprised of more than 50% by the euro zone, EUR/USD is quite inversely related. Check it:
Next, take a look at a chart of EUR/USD.
It’s like a mirror image! If one goes up, the other most likely goes down.
Will you look at that? It seems like the trend lines almost inversely match up perfectly. This could be a big help to those big on trading EUR/USD.
If the USDX makes significant movements, you can almost surely expect currency traders to react to the movement accordingly.
Both the USDX and forex traders react to each other. Breakouts in spot USD pairs will almost certainly move the USDX in similar breakout fashion.
To sum it all up, forex traders use the USDX as a key indicator for the direction of the USD. Always keep in mind the position of the USD in the pair you are trading.
For example, if the USDX is strengthening and rising, and you are trading EUR/USD, a strong USD will show a downtrend on the EUR/USD chart.
If you are trading a pair in which the USD is the based currency, such as the USD/CHF, a rise in the USDX will most likely show a rise in USD/CHF charts like the one shown below.
Here are two little tips you should always remember:
- If USD is the base currency (USD/XXX), then the USDX and the currency pair should move the same direction.
- If USD is the quote currency (XXX/USD), then the USDX and the currency pair should move in opposite directions.
The Dollar Smile Theory
Ever wonder why the dollar strengthens both in times of tough luck and when the economy is booming like a Beyoncé single?
Well, so does everybody else. In fact, this really smart dude over at Morgan Stanley came up with a theory to explain this phenomenon.
Stephen Jen, a former currency strategist and economist, came up with a theory and named it the “Dollar Smile Theory.”
The Dollar Smile Theory Explained
His theory depicts three main scenarios directing the behavior of the U.S. dollar. Here’s a simple illustration:
Scenario #1: USD Strengthens Due to Risk Aversion
The first part of the smile shows the U.S. dollar benefiting from risk aversion, which causes investors to flee to “safe-haven” currencies like the dollar and the yen.
Since investors think that the global economic situation is shaky, they are hesitant to pursue risky assets and would rather buy up the less risky U.S. dollar regardless of the condition of the U.S. economy.
Scenario #2: USD Weakens to New Low Due to Weak Economy
Dollar drops to a new low.
The bottom part of the smile reflects the lackluster performance of the Greenback as the U.S. economy grapples with weak fundamentals.
The possibility of interest rate cuts also weighs the U.S. dollar down. This leads to the market shying away from the dollar. The motto for USD becomes “Sell! Sell! Sell!”
Scenario #3: USD Strengthens Due to Economic Growth
The dollar appreciates due to economic growth.
Lastly, a smile begins to form as the U.S. economy sees the light at the end of the tunnel.
As optimism picks up and signs of economic recovery appear, sentiment towards the dollar begins to pick up. In other words, the greenback begins to appreciate as the U.S. economy enjoys stronger GDP growth and expectations of interest rate hikes increase.
This theory appears to have been in play when the 2007 financial crisis began.
Remember when the dollar got a huge boost at the peak of the global recession?
That’s phase 1.
When the market eventually bottomed out in March 2009, investors suddenly switched back to the higher yielding currencies, making the dollar the winner of the “Worst Currency” award for 2009.
That’s phase 2.
So will the Dollar Smile Theory hold true?
Only time will tell.
In any case, this is an important theory to keep in mind. Remember, all economies are cyclical.
The key part is determining which part of the cycle the economy is in.