The trade-weighted U.S. Dollar Index (DXY) is the de facto benchmark used to gauge the value of the US dollar devised by the ICE. The index is a weighted geometric mean of the dollar’s value relative to a basket of six currencies, where both the constituents and the weights have little changed since the series began in 1973, except to account for the creation of the Euro. The index can be decomposed as follows:
Exhibit 1: The composition of the trade-weighted US dollar index (DXY)
| Currency | Weight |
| Euro | 57.6% |
| Japanese Yen | 13.6% |
| Pound Sterling | 11.9% |
| Canadian Dollar | 9.1% |
| Swedish Krona | 4.2% |
| Swiss Franc | 3.6% |
Source: ICE
The term ‘trade-weighted’, however, appears somewhat inappropriate on this occasion. For one, with the Euro accounting for nearly 60% of the index weight, it renders the DXY Index into a predominantly USD/EUR phenomenon, where the fate of the Euro has an outsized impact on the index value. For the period 1975-2015, the correlation coefficient between the two are as high as 0.98 based on monthly data (Exhibit 2), and on average, the EUR accounted for over two-thirds (69%) of the movements in the dollar index (Exhibit 3). Adding GBP, CHF and SEK into the equation, the index becomes overwhelmingly Europe-centric at 75% weighting.
Exhibit: 2: The DXY Index versus USD/EUR since 1975
Source: Bloomberg
Exhibit: 3: Breakdown of the 12 Month rolling returns of the DXY Index by currency
Source: Bloomberg
Actual trade data points to a different picture. The Euro Area currently represents 16.6% of US total foreign trade (imports plus exports), its position as the largest trading partner to the US was taken over by China in 2009, who today makes up 21.5% of US total foreign trade. Sweden and Switzerland, together accounting for 7.8% of the index, are also less significant compared to 30 years ago, not to mention that the Swedish Krona weighs heavier than the Swiss Franc, which in itself begs more questions. At present, Switzerland is the 11th largest player (1.8% of total trade), while Sweden ranks much further down at 23rd in size (0.7%).
Exhibit 4: US Total trade (import plus export) by country, in percentage terms
Source: Federal Reserve
In context to this, the other shortcoming in the composition of the index is consequently the lack of Emerging Market representation. The importance of Emerging Market countries as trading partners to the United States have risen over the past twenty years, in particular, the total trade in 2014 ranks China, Brazil, Mexico, South Korea, India, and Taiwan in the top ten by size, outnumbering their traditional developed market counterparts (Euro Area, Canada, Japan, and UK). This, in turn, means that 44% of the total US foreign trade is unaccounted for by the so-called ‘trade-weighted’ US dollar index. It therefore makes sense to consider alternative compositions and weights for the USD currency basket with a view to a more representative picture.
Such indices do already exist, although not widely adopted. A number of broad US dollar indices have been created that are closer aligned to evolving US trade patterns, including the US Trade-Weighted Broad Dollar Index[1] built by the Fed in 1998 consisting of a basket of 26 currencies that captures well over 90% of US international trade (weights as seen in Exhibit 4). The basket weights are adjusted annually, and the index can also be split into two sub-indices: Major Currencies and Other Important Trading Partners (OITP), where the weights are derived by rescaling the currencies’ respective weights in the broad index so that they sum to 1 in each sub-index.
The Major Currencies index closely resembles the DXY index in composition, consisting of the seven most liquidity-traded currencies with the only difference being the addition of the Australian dollar to the mix. The OITP index includes mainly EM trading partners and smaller players.
Exhibit 5: Federal Reserve US Trade-Weighted Indices (Real) versus DXY Index 
Source: FRED, Bloomberg
Equally weighting the currencies is another alternative that has been introduced by a number of parties in recent years. The FTSE Curex USD G8 Index includes, for example, includes a basket of equally-weighted G8 currencies: Australian Dollar, Canadian Dollar, Swiss Franc, Chinese Renminbi, Euro, Sterling, Japanese Yen, and the New Zealand Dollar.
We have also experimented with an index comprising of an equally-weighted currency basket of top ten US trading partners. The series correlates relatively closely to the DXY in its return patterns with a correlation coefficient of 0.7 since 1995, albeit breaking down into the individual components, it is apparent that the underlying drivers are very different. In particular, it shows that the recent bout of USD strength is a result of BRL and MXN weakness, in contrast to the EUR driven DXY.
Exhibit 6: Equally-weight US dollar index (Top 10) versus the DXY Index 
Source: Bloomberg, Cerno Capital
Other attempts to reformulate the US dollar index intend to compare the US dollar against the most liquidly-traded currencies, using either FX volume-weighted or equal-weighted methodologies, such as the Wall Street Journal Dollar Index (16 currencies) in the former category and the Dow Jones FXCM Dollar Index in the latter (4 currencies: EUR, GBP, JPY, AUD). The rationale behind this is to indicate financial market pressures on the dollar given that all the currencies trade in liquid FX markets and used as a speculative tool.
Exhibit 7: Correlation between various US dollar indices since 1975 (based on monthly data)
Source: Bloomberg
It is difficult to judge which method most effectively depicts the value of the dollar. The FX volume-weighted strategy will also have the same Euro skew as the DXY as the Euro is the second largest traded currency in the FX market (>30%). Equal-weighted indices will overstate the importance of some currencies. The Federal Reserve’s inflation-adjusted broad dollar index is perhaps more relevant to today’s investors, in particular, being able to examine dollar value in two different dimensions through the Majors and OITP sub-indices can be a useful tool. Although the DXY, for all its inadequacies, still tracks the more diversified Fed indices reasonably well (see correlation in Exhibit 7), and it is traded widely as the underlying for dollar-index futures. Investors needs to be aware however, of the driver behind the index movements, and also that the DXY gives only a partial representation of dollar value and will not be able to capture significant movements outside its limited currency spectrum, the CNY devaluation back in August being a prime example.
Elements of this article first appeared in the Financial Times.
The trade-weighted U.S. Dollar Index (DXY) is the de facto benchmark used to gauge the value of the US dollar devised by the ICE. The index is a weighted geometric mean of the dollar’s value relative to a basket of six currencies, where both the constituents and the weights have little changed since the series began in 1973, except to account for the creation of the Euro. The index can be decomposed as follows:
Exhibit 1: The composition of the trade-weighted US dollar index (DXY)
| Currency | Weight |
| Euro | 57.6% |
| Japanese Yen | 13.6% |
| Pound Sterling | 11.9% |
| Canadian Dollar | 9.1% |
| Swedish Krona | 4.2% |
| Swiss Franc | 3.6% |
Source: ICE
The term ‘trade-weighted’, however, appears somewhat inappropriate on this occasion. For one, with the Euro accounting for nearly 60% of the index weight, it renders the DXY Index into a predominantly USD/EUR phenomenon, where the fate of the Euro has an outsized impact on the index value. For the period 1975-2015, the correlation coefficient between the two are as high as 0.98 based on monthly data (Exhibit 2), and on average, the EUR accounted for over two-thirds (69%) of the movements in the dollar index (Exhibit 3). Adding GBP, CHF and SEK into the equation, the index becomes overwhelmingly Europe-centric at 75% weighting.
Exhibit: 2: The DXY Index versus USD/EUR since 1975
Source: Bloomberg
Exhibit: 3: Breakdown of the 12 Month rolling returns of the DXY Index by currency
Source: Bloomberg
Actual trade data points to a different picture. The Euro Area currently represents 16.6% of US total foreign trade (imports plus exports), its position as the largest trading partner to the US was taken over by China in 2009, who today makes up 21.5% of US total foreign trade. Sweden and Switzerland, together accounting for 7.8% of the index, are also less significant compared to 30 years ago, not to mention that the Swedish Krona weighs heavier than the Swiss Franc, which in itself begs more questions. At present, Switzerland is the 11th largest player (1.8% of total trade), while Sweden ranks much further down at 23rd in size (0.7%).
Exhibit 4: US Total trade (import plus export) by country, in percentage terms
Source: Federal Reserve
In context to this, the other shortcoming in the composition of the index is consequently the lack of Emerging Market representation. The importance of Emerging Market countries as trading partners to the United States have risen over the past twenty years, in particular, the total trade in 2014 ranks China, Brazil, Mexico, South Korea, India, and Taiwan in the top ten by size, outnumbering their traditional developed market counterparts (Euro Area, Canada, Japan, and UK). This, in turn, means that 44% of the total US foreign trade is unaccounted for by the so-called ‘trade-weighted’ US dollar index. It therefore makes sense to consider alternative compositions and weights for the USD currency basket with a view to a more representative picture.
Such indices do already exist, although not widely adopted. A number of broad US dollar indices have been created that are closer aligned to evolving US trade patterns, including the US Trade-Weighted Broad Dollar Index[1] built by the Fed in 1998 consisting of a basket of 26 currencies that captures well over 90% of US international trade (weights as seen in Exhibit 4). The basket weights are adjusted annually, and the index can also be split into two sub-indices: Major Currencies and Other Important Trading Partners (OITP), where the weights are derived by rescaling the currencies’ respective weights in the broad index so that they sum to 1 in each sub-index.
The Major Currencies index closely resembles the DXY index in composition, consisting of the seven most liquidity-traded currencies with the only difference being the addition of the Australian dollar to the mix. The OITP index includes mainly EM trading partners and smaller players.
Exhibit 5: Federal Reserve US Trade-Weighted Indices (Real) versus DXY Index
Source: FRED, Bloomberg
Equally weighting the currencies is another alternative that has been introduced by a number of parties in recent years. The FTSE Curex USD G8 Index includes, for example, includes a basket of equally-weighted G8 currencies: Australian Dollar, Canadian Dollar, Swiss Franc, Chinese Renminbi, Euro, Sterling, Japanese Yen, and the New Zealand Dollar.
We have also experimented with an index comprising of an equally-weighted currency basket of top ten US trading partners. The series correlates relatively closely to the DXY in its return patterns with a correlation coefficient of 0.7 since 1995, albeit breaking down into the individual components, it is apparent that the underlying drivers are very different. In particular, it shows that the recent bout of USD strength is a result of BRL and MXN weakness, in contrast to the EUR driven DXY.
Exhibit 6: Equally-weight US dollar index (Top 10) versus the DXY Index
Source: Bloomberg, Cerno Capital
Other attempts to reformulate the US dollar index intend to compare the US dollar against the most liquidly-traded currencies, using either FX volume-weighted or equal-weighted methodologies, such as the Wall Street Journal Dollar Index (16 currencies) in the former category and the Dow Jones FXCM Dollar Index in the latter (4 currencies: EUR, GBP, JPY, AUD). The rationale behind this is to indicate financial market pressures on the dollar given that all the currencies trade in liquid FX markets and used as a speculative tool.
Exhibit 7: Correlation between various US dollar indices since 1975 (based on monthly data)
Source: Bloomberg
It is difficult to judge which method most effectively depicts the value of the dollar. The FX volume-weighted strategy will also have the same Euro skew as the DXY as the Euro is the second largest traded currency in the FX market (>30%). Equal-weighted indices will overstate the importance of some currencies. The Federal Reserve’s inflation-adjusted broad dollar index is perhaps more relevant to today’s investors, in particular, being able to examine dollar value in two different dimensions through the Majors and OITP sub-indices can be a useful tool. Although the DXY, for all its inadequacies, still tracks the more diversified Fed indices reasonably well (see correlation in Exhibit 7), and it is traded widely as the underlying for dollar-index futures. Investors needs to be aware however, of the driver behind the index movements, and also that the DXY gives only a partial representation of dollar value and will not be able to capture significant movements outside its limited currency spectrum, the CNY devaluation back in August being a prime example.