What Is the DXY Dollar Index and How Does It Work
The DXY Dollar Index, which is also called the U.S. Dollar Index (USDX) for short, is a benchmark measure of the value of the United States dollar (USD) against a basket of six foreign currencies, and is a commonly known measure for forex traders, economists, and investors looking at how strong or weak the dollar is in the global marketplace.
The DXY Index
The DXY measures the USD against a basket of six currencies from the most significant trading partners of the United States:
Euro (EUR) – weight of ~57.6%
Japanese Yen (JPY) – weight of ~13.6%
British Pound (GBP) – weight of ~11.9%
Canadian Dollar (CAD) – weight of ~9.1%
Swedish Krona (SEK) – weight of ~4.2%
Swiss Franc (CHF) – weight of ~3.6%As can be seen, the Euro holds the most significant weighting in the DXY index, therefore changes to the EUR/USD currency pair will be the largest determinant of changes in DXY values.
How is the DXY Calculated
The DXY is a geometric weighted average of the value of the dollar against the above-listed currencies. The calculation takes the exchange rate of the USD against each of the currencies and applies each currency’s respective weight in the calculation. Importantly, the DXY index is not a static measure and instead is a current measure of the changing currency markets.
A Brief Historical Background
In 1973, following the collapse of the Bretton Woods system, the U.S. Federal Reserve created the DXY index with an initial basket of currencies sourced from its then-key trade partners. While global trade has changed in terms of size, focus, and destination, the index structure has remained the same, which has led to critiques about the lack of relevance and dated structure of the DXY.
Why Does the DXY Matter?
The DXY is just not another number; it is a market sentiment. This is why it is one of the most commonly used indexes:
Traders use it to refer to the strength of the dollar as well as to anticipate trends in forex trading.
Investors track to DXY when measuring an asset denominated in dollars (i.e. oil, gold, bonds).
Policy makers monitor when they want to measure the USD against its global competitors.
International businesses take it into account when planning out futures hedges.DXY and Economic Indicators
There is a series of economic indicators that are reflective in the DXY movement, which include:
Interest rates from the Federal Reserve
Inflation, as measured by CPI and PPI
Employment numbers - i.e. non-farm payrolls, unemployment rate
GDP growth
Geopolitical events Typically, if the U.S. economy is performing at a moderate – strong level, and if the Fed is pushing rates higher, the DXY is expected to increase. Typically, if economic data is weak or the Fed indicates a dovish stance, expect to the dollar to weaken.
In the Forex Market, DXY
Many Forex traders look to the DXY in decision making or confirmation of trends. For example:
If the DXY is trending up, the USD has strength, which might suggest possible short trades on EUR/USD, GBP/USD, etc.
If the DXY breaks important resistance levels that can suggest that demand for the USD is increasing across multiple currency pairs. Critique and Limitations
The DXY, while a widely respected resource, does have limitations.
The DXY does not include currencies from emerging markets and large exporting countries as members; China (CNY) and Mexico (MXN) for example.
The DXY composition has historical significance but does not reflect the state of trade today, it has been flat for many decades.
In order for evaluation by Forex traders, DXY must be combined with stick or commodity charts because DXY is a broad measure and must not be taken to be market-specific but rather asset-specific.Conclusion
The DXY Dollar Index, while limited, is an important resource for all people who are involved in currencies and it may be necessary to keep the limitations in mind.
It remains important before doing a position of any trader. Understanding the DXY and how it works, as well as being able to assess those movements in a currency context will allow a trader, investor, or policy expert to make a more educated decision in what is becoming an increasingly connected global financial landscape.
