The Dollar Currency Index serves as a crucial metric for establishing the relative strength of the US Dollar within a wider macroeconomic landscape. The DXY, or Dixie as it is sometimes referred to, offers instant insight on the performance of the Dollar compared to other currencies. Let us take a closer look at it.

BRETTON WOODS

As with many things, the World Wars were the spark that set things in motion. After the First World War, Europe lay in ruins; it was time to rebuild. The Treaty of Versailles, written by the victorious parties, essentially passed the entire bill of the conflict to Germany, inevitably bankrupting them. This was a major contributing factor to the advent of the Second World War, which would lead to similarly destructive consequences in Europe and further afield.

Determined not to repeat the “beggar thy neighbour” policies of the past, economists and leaders from around the world set out to establish an international monetary framework as the basis for reconstruction. During the closing stages of the war, delegates gathered at Bretton Woods, New Hampshire, to establish how the new financial system would function:

- Firstly, the US Dollar would be fixed to $35 per troy ounce of gold

- Secondly, each member country of the agreement would guarantee convertibility of their own money to the Dollar according to pre-established currency pegs.

 The above would result in the USD becoming the de facto world reserve currency. As an addendum, the conference also resulted in the creation of the International Monetary Fund (IMF) as well as other entities that would go on to form the World Bank.

Over the next few decades, the system worked incredibly well. Perhaps a little too well. Due to its convertibility to gold, the Dollar became very attractive, both domestically and internationally. To keep pace with increased demand, more Dollars were printed. So much so that by the 1970s, there were four times more Dollars in circulation than could be backed up by the gold reserves of the time. This meant that the Dollar was extremely overvalued, which was a problem in its own right, but led to the other issue of huge gold outflows out of the US.

By the time Richard Nixon took office, the situation was untenable. The system that was arguably responsible for post-war economic stability and growth had to go. The Bretton Woods system was abandoned and the Dollar taken off the gold standard. This created a problem: by severing the tether between the Dollar and gold, suddenly there was nothing to properly ground the value of the American currency, and by extension, every other currency pegged to it.

THE DXY

If a currency is not tied to anything, then what gives it value? The many answers to this question fall outside of the scope of this article so let us turn instead to the answer provided by the Federal Reserve. Their solution to this new problem was to create an index that weighed the strength of the Dollar against the currencies of the US’ most common trading partners.

At the time of its implementation in 1973, this meant the inclusion of the following 10 currencies: the Japanese Yen, the Canadian Dollar, the Deutschmark, the Pound Sterling, the Italian Lira, the Dutch Guilder, the Swedish Krona and the French, Belgian and Swiss Francs. After the adoption of the Euro by many European nations around the turn of the millennium, the basket consolidated from 10 currencies down to the current six according to the following ratio:



Taking the above weightings into account, the formula for calculating the DXY is as follows:



One may notice the negative exponent for the Euro and Cable. We leave the reasoning as to why as an exercise for the reader. The purpose of the constant is to peg the first calculation to a value of 100. The index is therefore to be read as follows: a value below 100 is to be understood as an indication of a weak Dollar; and the obvious corollary.

Although established by the Fed, the task of calculating the DXY currently falls to the Intercontinental Exchange (ICE), which introduced a tradeable futures contract tied to the index back in 1985. It would be during this very year that the DXY printed its highest ever value, coming in just shy of 164.

In contrast, the period surrounding the 2008 financial crisis was characterised by lower interest rates in the US compared to other countries, comparatively devaluing the Dollar and causing the DXY to fall as low as 70 in the first half of that year.

CRITICISM

The index has not changed in its composition since its introduction half a century ago. The Euro merely substituted the currencies it replaced, taking their combined weighting as its own. This is the source of much of the criticism currently levelled against the DXY. The world has changed considerably since 1973, economically and otherwise. Let us remind ourselves that the currency basket of the DXY was defined by the largest trading partners of the United States at the time, which as of 2021 stood as follows:



As we can see, the composition of the DXY doesn’t follow the above chart at all. Despite making up 57% of the weighting of the basket, the truth is that only 15% of US trade occurred with Eurozone countries. Meanwhile, due to its strongly emergent economy and solid manufacturing base, trade with Mexico continues to ramp up, now challenging China and Canada for the top spot.

If the index is meant to be a reflection of the strength of the Dollar on the world stage, then why does it not include the Mexican Peso, or indeed the Chinese Renminbi, or even the Korean Won? Conversely, and with absolutely no offense to Sweden, is the inclusion of the Swedish Krona really justified in this day and age?

The other, perhaps more fundamental criticism, is that none of this matters because none of the currencies mentioned in this article have any inherent value anyway. By definition, the DXY tells us the relative value of the Dollar compared to other currencies. The problem being that all of these currencies are locked in a race to the bottom, relentlessly eroded by inflation, year after year. 35 bucks certainly won’t buy an ounce of gold anymore.

Overly harsh criticism no doubt. The DXY remains ubiquitous in the financial world in no small part because of its use to traders. Given that the USD is on one side of almost 90% of all forex trades, it can more than justify its own index. Although perhaps one more grounded in the present day.