The US Dollar Index: four indices, four answers
There is no such thing as the price of the dollar — only its price against something else. A dollar index is an attempt to make one number out of that, and there are four of them that disagree.
Lesson 6 of 12.
Why a dollar index exists at all
Every currency price is a ratio. EUR/USD rising can mean the euro strengthened, the dollar weakened, or both by different amounts — and the pair cannot tell you which. That is a real problem, because almost everything in this branch is a statement about the dollar: the rate decision in lesson nine, the yield in lesson eight, the inflation print in lesson ten.
A dollar index solves it by measuring the dollar against a basket instead of against one counterpart. If the index rises while EUR/USD falls, the dollar strengthened. If the index is flat while EUR/USD falls, the euro weakened and the dollar did nothing — a completely different trade.
Which is the first practical use of this lesson, and it costs nothing: before deciding a pair moved, check whether the dollar moved.
Four indices, four answers
The source lists four, and the differences between them are not academic — they are the reason two traders can look at "the dollar" and disagree.
DXY, the ICE dollar index, is the one most platforms mean by "the dollar index". Its composition has been essentially fixed since 1973: the euro at about 57.6 per cent, then the yen, sterling, the Canadian dollar, the Swedish krona and the Swiss franc. More than half of it is one currency, which means DXY is substantially a EUR/USD chart drawn upside down.
BBDXY, the Bloomberg dollar index, weights by a combination of trade flows and market liquidity and is reweighted every year. It includes currencies DXY has never had — the Chinese yuan and the Mexican peso among them — so it tracks where America actually trades rather than where it traded in 1973.
DJ FXCM takes four pairs and weights them equally: EUR/USD, AUD/USD, USD/JPY and GBP/USD, 25 per cent each. Crude, but it removes the euro dominance in one step, and it responds to the Australian dollar — a resource currency, from lesson three — which the others barely notice.
Trade-weighted indices, published by the Federal Reserve, weight each currency by how much the United States actually trades with that country. This is the one an economist reaches for and the one a trader reaches for least, because it is slower to publish and less liquid to trade against.
Which one to watch
The honest answer is that it depends what you are asking, and the choice is not arbitrary.
- Trading EUR/USD — DXY is the wrong instrument, because it is more than half euro. You would be confirming a pair against a proxy for itself. Use DJ FXCM or BBDXY.
- Trading a commodity — DXY is fine, because commodities are priced in dollars and the liquidity in the index is what matters.
- Asking whether the dollar is genuinely strong — look at two of them. When DXY and BBDXY agree, the dollar moved. When they disagree, the euro did.
- Reading a central bank's own view of the currency — trade-weighted, because that is the one policy is actually concerned with.
What the dollar index moves against
The source ends this section with four correlation charts, and they are the payoff of the whole lesson.
Gold (XAU/USD) — inverse. Gold is quoted in dollars, so a stronger dollar buys more of it and the quoted price falls before anything about gold has changed. On top of that, gold pays no interest, and the same conditions that lift the dollar usually lift yields, which makes holding it more expensive.
Crude oil (WTI) — inverse, and this answers the source's own exercise. Oil is priced in dollars worldwide. If the dollar rises, every non-American buyer is paying more in their own currency for an unchanged barrel, so demand at the quoted price falls and the price adjusts down. The mechanism is arithmetic before it is economics.
The S&P 500 — weak, and not stable. This is the second exercise and the answer is that there is no reliable sign. A strong dollar hurts the overseas earnings of American multinationals, which is negative; but a strong dollar often reflects capital moving into American assets, which is positive. The two dominate at different times, so the correlation flips. Anyone quoting a fixed relationship here is describing one period.
USD/JPY — positive, and this one is nearly definitional: the dollar is the numerator of the pair and a component of the index, so they move together by construction.
A rule for using correlation without being caught by it
Correlation is the most over-trusted idea in this branch, so it is worth stating the discipline plainly.
- Only trade a correlation you can explain. Oil and the dollar have a pricing mechanism behind them; the dollar and the S&P 500 have two mechanisms that cancel. The first survives a change of regime, the second does not.
- A correlation is not a signal. It tells you two things usually move together — not which one leads, and not by how much.
- Two correlated positions are one position at double size. Long gold and short the dollar index is not diversification, and it is one of the most common ways a well-analysed account is over-exposed without the trader noticing.
- Check the sign is still the sign. Relationships built on interest rate differentials invert when the differential inverts, which is precisely what lesson eight is about.
What to take from this one
Three things:
- A pair cannot tell you which side moved. A dollar index can, and checking it before attributing a move is free.
- The four indices disagree because their weights disagree. DXY is more than half euro, so it is the wrong confirmation for a EUR/USD trade and the right one for a commodity.
- Gold and oil move against the dollar for a reason you can state in one sentence. The S&P 500 does not, which is why that one is not tradeable.
Next: what money costs, and who decides it
Money supply from M0 up, the interest rate as the price of money, and how a statement and a dot plot are read for what they imply rather than what they say.