Why you Should NOT Follow the Dollar Index (DXY)
The Dollar rallying out of its summer weakness is beginning to catch the attention of mainstream commentators.
Unfortunately, their focus isn’t on the Dollar per se, but rather the Dollar Index, which is not a very good indicator of USD performance at all.
What should you be looking at instead?
Before we take a look at the different methods of gauging Dollar strength or weakness, it is important to understand why we need to be looking at the USD at all.
Obviously, the USD is the world’s reserve currency and is thus of global importance. Everyone knows this, but they don’t really understand why.
The common belief is that the Fed controls the supply of Dollars around the world, because the Fed can print USDs at will.
However, this isn’t accurate.
The Fed controls the supply of USD denominated bank reserves, which, contrary to popular belief, are not really money. They are a settlement currency which can only be used by banks.
The clearest way to see that bank reserves aren’t money is to realize that banks do not lend them out when making loans.
In other words, the supply of Dollars is controlled by banks.
When they decide to loan more Dollars, the supply of USDs in the world increases, and when they do not, it stays the same or decreases (as loans mature).
Consequently, the USD is the world’s reserve currency because the banks in the global financial system have chosen to use it as such, which makes the supply of USDs around the globe the world’s de facto money supply.
This in turn makes the USD the most important market to watch, as its value directly tells us whether or not the world is being supplied with enough Dollars.
If it is, the global economy can keep growing, or at least hum along; if not, recession or crisis lies around the corner.
If you want to learn more about the USD’s importance to the world’s economy, as well as how the system works, check out our course on how to make money trading a crisis.
Unfortunately, observing the USD’s value is not as straightforward as one might think. As currencies are always quoted against another, this means that the Dollar has different values against different currencies.
There isn’t a single number one can look at which comprehensively tells us the value of the Dollar.
Which is why folks like to use the Dollar Index (DXY), as it provides the convenience of a single number that they can look at.
Unfortunately, the Dollar Index does a poor job of showing us the USD’s value versus its peers. This is because:
- It is comprised of only 6 currencies, the Euro (EUR), Japanese Yen (JPY), British Pound (GBP), Canadian Dollar (CAD), Swedish Krona (SEK), and Swiss Franc (CHF)
- These 6 currencies do not represent a wide spectrum of the world’s economies
- It is too heavily skewed towards the Euro, which bears an index weight of 60%
Simply put, the scope of the DXY is too restricted.
In order to get a decent understanding of the Dollar’s performance versus the world’s currencies, we need to track its value against currencies which represent different types of economies, from all over the world.
A decent alternative to the DXY is the Broad Dollar Index (DTWEXBGS). This index is constructed by the Fed, and measures the Dollar’s value against more than 20 currencies.
While this makes it a much better alternative to the DXY, the DTWEXBGS isn’t calculated and made available on a real time basis; the latest reading of the index made public by the Fed tends to lag by a few days.
As such, the DTWEXBGS will give a much more accurate picture of what the Dollar is doing over a period of time than the DXY, but not a real time one.
On the other hand, the DXY can give us a real time snapshot of Dollar performance, but not a very broad one.
Of course, you could also follow a variety of individual currency pairs to gain your own view on Dollar performance. This method would give you the best of both worlds – breadth and a real time perspective, at the expense of ease and convenience.
If you want to learn how to use the Dollar’s strength, or weakness, as an indicator in a broader trading framework, we teach you how to do so in our course on how to trade global macro.
Ultimately, pick whichever suits your needs better, or use one in conjunction with the other.
Just make sure that you are following the USD!
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