Understanding and Using the Dollar Index
November 12, 2009
The folks on CNBC and elsewhere in the media are all over the fact that the Dollar Index got below 75 yesterday, the lowest level since August 2008 (the lowest point was about 70.70 in March 2008). Yes, the dollar has been weakening pretty consistently from the time stocks turned north in March, but there’s something you need to be aware of here. The dollar index is more than half weighted to the euro. Here are the weights as per this document from the ICE.
Euro = 57.6%
Japanese yen = 13.6%
British pound = 11.9%
Canadian dollar = 9.1%
Sweden krona = 4.2%
Swiss franc = 3.6%
In other words, the main driver of the Dollar Index is EUR/USD – even more so when you consider how closely correlated the euro and swiss franc are. That means the index can be skewed at different points as the EUR either over- or under- performs. That creates a potential opportunity to look for divergences between the two.
As you can see above, while the index and EUR/USD matched turning points in late 2005, they diverged at the more recent ones. That could have tipped you off that something was changing, just like looking at divergences in indicators or stock market internals.
The problem, though, becomes when looking at something beyond the euro, like USD/JPY.
Notice how relatively un-related the path of USD/JPY has been compared to the course of the index. That tells you there are other considerations involved here related to the yen which don’t reflect in the general dollar situation.
Being able to see the differences in how related markets trade can go a long way to help you make good trades.
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