The Ailing US Dollar Index

July 07, 2011

The U.S. Dollar Index has been the go-to benchmark to value the dollar in other currencies since 1973. Too bad it’s so flawed.

Just as one would expect a plain-vanilla equity index to be market-cap weighted, a currency index, ideally, ought to be weighted based on some measure of trade between countries. Unfortunately, the U.S. Dollar Index falls far short of that.

The Federal Reserve has long provided data on trade and even publishes a trade-weighted U.S. Dollar Index. However, use of this index has been downplayed because of a lack of liquidity of some of the underlying currencies. But times have changed.

Take China, a large and growing U.S. trading partner. Its economy could be as big as the U.S.’ within half a decade, but there isn’t a trace of yuan in the U.S. Dollar Index. Sure, the yuan still floats less than freely, but it’s beginning to. It just seems preposterous to me that it’s excluded from the index.

This isn’t just an academic discussion. The U.S. Dollar Index’s composition affects the way that ETFs benchmarked to the index work.

I’ll get to that, but for the record, let’s take a look at the current composition of the US. Dollar Index:

Currency Weights

When we look at trade-weighted data that reflects how dollars circulate in the global economy, it’s even more alarming just how out of sync the U.S. Dollar Index is, especially in comparison with the trade-weighted U.S. Broad Dollar Index:

Trade Weighted Dollar Index Weights

It’s easy to see that the euro is overweight in the U.S. Dollar Index, but take a closer look at what else is going on.

Just as China or Mexico ought to be included because they are such important U.S. trading partners, you’ve got to wonder why a country like Sweden has a 4.2 percent weighting in the index. I get that it’s because so much of its currency trades freely outside its borders, but come on.

I also understand the consideration given to liquidity. But when valuing the dollar in the truest sense, it’s illogical to say that China should be thrown out, dirty float notwithstanding. Also, excluding the Mexican peso, now the 12th-most-traded currency in the world, the U.S. Dollar Index isn’t doing investors any good when it comes to understanding the value of the dollar on a global level.

 

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