The DXY is an indicator that many market observers and commentators reference and cite. So what is the DXY or US dollar index?
The DXY is a geometrically weighted index of some of the major trading partners of the United States. The composition if the DXY index is heavily weighted towards the euro and European countries that have not joined the European common market. The components of the DXY index are (by weight): Euro (57.6%), Japanese Yen (13.6%), Great Britain – British Pounds (11.9%), Canadian Dollar (9.1%), Crown Swedish (4.2%) and Swiss Franc (3.6%). Due to the composition of the DXY, it is sometimes referred to as the Anti-Euro Index.
The DXY is a convenient index to use as a simple method to reference the strength and weakness of the United States dollar (USD). But its ubiquity hides the fact that it does not reflect the value of the dollar against a large enough basket of currencies. The DXY was created by JP Morgan in 1973 and has only been updated once, for the introduction of the euro.
DXY is heavily weighted toward European currencies, is underweight the Canadian dollar, as a proportion of US trade, and largely ignores major Asia-Pacific trading partners, including Korea, Australia, Taiwan, and necessarily China. Even if one were interested in including the Chinese renminbi (yuan), it would be difficult and of doubtful informational value to include the renminbi because China keeps its currency pegged in a range that is based on the dollar.
A more accurate basket of currencies for tracking the relative value of the USD would be to value the dollar against the major US trading partners.The top six US trading partners, from highest to lowest, are: Canada, China, Mexico, Japan, Germany and the United Kingdom. It is difficult to say why JP Morgan created this index and how it gained such prominence. One weird thing about this index is that you cannot trade it. There is no market that you can go to and buy the DXY. The closest you can get are futures and options contracts traded on the InterContinental Exchange (ICE).
If it is so inaccurate, why is it so widely cited? While there are more accurate ways to compare the USD, absolute accuracy is not always important for an indicator. Many traders and institutions likely have their own indices that they use to track the USD, but for the sake of comparison, it is very convenient to have a common index. The DXY is also highly correlated with a trade-weighted index most of the time. Movements of relative strength or weakness in the USD represent huge money flows. As I wrote earlier, the recent + 10% move in the DXY represents over $ 1 trillion of nominal wealth destruction. Movements of this magnitude do not occur in a vacuum and the relative weakness of the DXY is reflected in the corresponding weakness in the trade-weighted index.
While there are shortcomings, the DXY serves as a reliable indicator of the strength and weakness of the USD and can be used as such, provided that it is taken into account that it will occasionally deviate if there are large currency movements in the euro.