The Dollar Index (USDX) and dollar smile theory
If you have already invested in the stock market, you are probably already familiar with indexes such as the DAX, FTSE 100, the Russell 2000 or the S&P 500.
Traders also use currency indices. The best known one is the U.S. Dollar Index (USDX). The Dollar Index consists of a weighted average of a basket of foreign currencies against the dollar.
The Dollar Index consists of six currencies:
- Euro (EUR)
- Yen (JPY)
- Pound (GBP)
- Canadian dollar (CAD)
- Krona (SEK)
- Franc (CHF)
In all, 22 countries are represented, because there are 17 members of the European Union that use the euro, as well as the other five countries (Japan, Britain, Canada, Sweden, and Switzerland) and their respective currencies.
It is obvious that 22 countries represent only a small part of the world, but many other currencies follow the U.S. Dollar Index closely. The USDX is therefore a good tool to measure the overall strength of the U.S. dollar.
Composition of the USDX
As the countries are not all the same size, their weight is distributed according to a "geometric weighted average" for the calculation of the U.S. Dollar Index.
- EUR 57.60%
- JPY 13.60%
- GBP 13.60%
- CAD 9.10%
- SEK 9.10%
- CHF 3.60%
The Dollar Index is therefore strongly influenced by the euro, which represents 57.60% of the index. The correlation between the EUR and the USDX is negative. Most of the time, when the dollar index goes up, the other currencies fall (especially the euro).
Using the USDX
Most currency pairs used for trading include the U.S. dollar. The most popular are:
- EUR / USD
- GBP / USD
- USD / CHF
- USD / JPY
- USD / CAD
If you trade these currency pairs, the USDX can be useful to get an idea of the relative strength of the U.S. dollar in the world. The USDX is an indicator of the strength of the U.S. dollar in the world.
When the USDX is restless and volatile, traders often tend to act accordingly. The currencies react among each other according to their degree of correlation. This correlation is very strong with the EUR/USD since it represents 57% of the USDX.
To summarise things, traders use the USDX as a key indicator of the dollar's trend.
If the USD is the base currency (USD/XXX), the USDX and the currency pair should move in the same direction.
If the USD is the quote currency (XXX/USD), the USDX and the currency pair should move in opposite directions.
The Dollar Smile theory
The dollar smile theory - as described by Stephen Jen, a former currency strategist and economist at Morgan Stanley - consists of three phases, here is a simple illustration:
Phase 1 - When risk aversion rises, the dollar rises
The left side of the smile shows that the U.S. dollar benefits from risk aversion. The world's economy is beginning to show the first signs of potentially serious problems. Investors are worried and they begin to flee toward "shelter" currencies such as the dollar and the yen. During this phase, the objective of investors is to save their money rather than earn more.
Phase 2 - Economic slowdown and recession
The middle of the smile shows a falling dollar. The economy is showing clear signs of a slowdown or even a recession, and the Fed begins to reduce interest rates. Demand for the greenback is weak and the dollar sinks.
Phase 3 - Economic growth
Gradually, the situation improves, and fundamentals begin to point to an improving economic environment. Economic players anticipate expansion, they increase production, demand for loans begins to rise and appetite for risk has returned. Optimism returns and investors are willing to take more risks. The greenback begins a new upswing thanks to the U.S. economy - which is experiencing higher GDP growth - as well as expectations that the Fed will be increasing interest rates.
Monthly chart of the USDX
Annual GDP growth
Remember, all economies are cyclical. If you are able to identify what part of the cycle the economy is in, you can anticipate long term forex trends.
