The DXY is an indicator that many observers and market commentators refer to and cite. So, what is the DXY or US Dollar index?
The DXY is a geographically weighted index of some of the major trading partners in the United States. The composition if the DXY Index is heavily weighted for European and European countries that have not adhered to the European common market. The components of the DXY index are: Euro (57.6%), Japanese Yen (13.6%), Great Britain – British Pound (11.9%), Canadian Dollar Swedish krona (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 US dollar (USD). But its ubiquity disguises the fact that it does not reflect the value of the dollar against a rather large basket of currencies. The DXY was created by JP Morgan in 1973, and was only updated once by the introduction of the euro currency.
The DXY is heavily weighted against the European currencies, it is lower than the Canadian dollar as a proportion of US trade, and largely ignores the important trading partners of Asia and the Pacific, including Korea, Australia, Taiwan and, necessarily, China. Even if someone were interested in including the Chinese Renminbi (Yuan), it would be difficult and of questionable informational value to include the Renminbi because China keeps its currency indexed to a range that is based on the dollar.
The more accurate basket of currencies to track the relative value of the USD would be to assess the dollar against the major US trading partners. The top 6 US trading partners from top to bottom are: Canada, China, Mexico, Japan, Germany and UK. It is hard to say why JP Morgan created this index and how it came to such prominence. One weird thing about this index is that you can not trade it. There is no market where you can go and buy DXY. The closest you can get are futures and options contracts traded on the InterContinental Exchange (ICE).
If it's so inaccurate, then why is it so widely quoted? While there are more accurate ways to compare the USD, absolute accuracy is not always important for an indicator. Many traders and institutions probably have their own indices that they use to track the USD, but for comparison reasons, it is very convenient to have a common index. DXY is also highly correlated with a trade-weighted index most of the time. The relative strength or weakness of the USD represents huge flows of money. As I wrote earlier, the recent + 10% move by the DXY represents over $ 1 trillion of nominal destruction of wealth. Movements of this magnitude do not occur in the vacuum and the relative weakness of the DXY is reflected by the corresponding weakness in the trade-weighted index.
Although there are deficiencies, the DXY serves as a reliable indicator of USD strength and weakness and can be used as such provided it is kept in mind that it will occasionally be diverted if there are major currency movements occurring in the euro.
Source by Christian Koch