The problem that many pundits have, and don’t seem to be aware of, is that they are applying a measure of dollar strength (weakness) incorrectly. By making macroeconomic judgments based on a flawed index of relative currency valuation, they show their ignorance.
In a logical process of forecasting economic events through dollar strength (weakness), there are two steps. The second step, and subject to a future post, is correctly extrapolating how, if at all, dollar strength (weakness) impacts future events. The first step, however, is correctly measuring the strength (weakness) of the dollar relative to other currencies. This is a flaw in the approach of “brand x,” similar to their flawed use of the 10-city S&P HPI instead of the more comprehensive measures available.
The U.S. Dollar Index ($USD or USDX) is a futures contract. As such, it’s tradable. Yippee, because that’s the only thing it’s got going on. It’s calculated based on a geometric weighting to six other currencies, as follows:
USDX = 50.14348112 × EURUSD^(-0.576) × USDJPY^(0.136) × GBPUSD^(-0.119) × USDCAD^(0.091) × USDSEK^(0.042) × USDCHF^(0.036)
As you can see, the Eurozone exchange accounts for about 58% of the weight, and other European countries account for another 20%. The only non-European countries involved in the index are Canada and Japan. This contract is sometimes derisively (and appropriately IMO) called the “anti-Euro index.”
Quite frankly, it is retarded to use this index as anything other than a trading vehicle. To make macroeconomic assumptions or judgments based on dollar strength (weakness) as measured by the USDX is a sign of ignorance. Unfortunately, I have grown used to such ignorance from the pundits in question, including the ubiquitous “all-time low” hyperbole.
According to data from the St. Louis Fed, the European countries that make up over 75% of the USDX’s weight only account for 25% of U.S. foreign trade. From a macroeconomic standpoint, their importance is far less than one would imagine, if using the USDX as a yardstick.
In contrast, the two countries with the largest amount of U.S. foreign trade, that are unlisted in the USDX, account for more foreign trade with the U.S. than the 16 European countries respresented by four currencies in the USDX do!
China + Mexico = 24.728% of trade
Eurozone + U.K. + Switzerland + Sweden = 24.572% of trade.
Matter of fact, the six currencies (representing 18 countries) in the USDX only account for 50% of U.S. foreign trade.
It’s pretty fascinating to take that data from the St. Louis Fed and track the “majors” (selected because the currencies trade widely) and the “minors” separately, or, alternately, track those in the USDX separately from those not in the USDX. The results are similar.
From 1973 to 1978, the “majors” accounted for 70-75% of U.S. foreign trade. That crossed below 60% in 1996, and is now close to falling below 50%. Over three decades, the trend has been that the U.S. increasingly does trade with partners that (1) it never traded with in any size before and (2) have weak and falling currencies, relative to the U.S. dollar. The “all time lows” that the U.S. dollar is making against the trading partners of the past aren’t as important economically as the relative strength of the dollar is versus the trading partners of today.
So what does this mean in terms of dollar strength (weakness), from a macroeconomic point of view?
First, it would make sense for you to view the chart of the U.S. trade-weighted dollar. Yes, it’s apparent that the dollar has seen a half-decade of weakening versus its trading partners, but it is far from a historic low in valuation, relative to what counts – foreign trade – in a macro sense. Remember that the pattern of foreign trade is not static, and has, indeed, been shifting over time. It will continue to shift.
Second, if these pundits have built any mathematical models for economic forecasting based on the USDX futures contract, it might behoove them to consider using a trade-weighted model of dollar strength (weakness), as trade will likely have more influence on economic policy than FX speculation will. While the USDX currency weights may once have reflected an economic reality, those weights are profoundly out of touch with reality today, and the contract is pure speculation with little macroeconomic importance.
Third, if you’re taking the opinions of “brand x” about dollar strength (weakness) into account, you may want to start taking them with a large grain of salt.
6 Comments
Fascinating. Great post.
Thanks Bill. I’m glad someone finally pointed that out. The idea of a dollar index with one currency weighted at more than 1/2 the value is a farce in terms of representing anything real and meaningful.
The only flaw in the argument is that Japan, China and others participate are, the very least, loosely pegged to the dollar by their central Banks. China, Japan, and most of Asia and some Middle Eastern countries. I would argue that the dollar is being artificially supported by their Mercantalistic trade policies. This also may be putting artificial strength in the Euro, as these currencies are kept weaker, the Euro may act as a relief valve.
As long as these countries maintain this policy, the US dollar will not collapse. But if they were to ever decide that the stable currecy relationship with the US dollar was no longer in their interests, then, it could be serious. They currently must feel that it is in their interest to protect the value of their rather large Dollar reserves.
But further recklessness by the Fed, Congress or the President could lead them to change their views. Demanding Yuan revaluation, trade sanctions, or protectionist policies that prevent acquisitions of US companies, are among things to fear.
@ David: Double-check the top 5 non-USDX countries in terms of U.S. trade (about 30% of trade BTW); none have a current dollar peg, incl. China, i.e., the Yuan is revaluing. They’re just doing it slowly so that the speculators don’t benefit overly much. Pull up 5-year charts at Yahoo! to see the lack of pegging.
FYI the gist of my argument is that the USDX is worthless for macro prediction, and a broader, trade-weighted index is needed for macro prediction. While your comment is presenting an economic prediction (that I don’t necessarily agree with), it actually bolsters my argument that the USDX is worthless in the predictive sphere of things, by your inclusion of some non-USDX countries in your reasoning.
I very much like the trade weighted Fed index shown. Would be good to have the ability to normalize to fixed year dollars for inflation purposes. Interesting to use the St.Lou Fed Chart to multi-line chart this.
That said, doesn’t it make some sense to use the ‘faulty’ USDX in discussions about oil, which is priced in either Dollars or Euros (>50% weighting) and/or against a basket of energy-intensive countries? (EU, JAP, etc.) It does to me, at least prima facie.
Second point: the trade-weighted index is great, but…raises questions. Is this a fixed index like USDX
against “current” major trade partners, or does it dynamically adjust season by season to account for changes in trading percentage over the years. I don’t think our trade with China, for example, was that major a fraction in 1985.
Thanks for your post!
The Fed data site, FRED II, has everything you would need to adjust based on whatever you chose to use, although you might have to export the data into a spreadsheet and do it yourself.
Why would we want to talk about oil in terms of dollar strength vs. other currencies? Isn’t oil priced based on supply vs demand and geopolitical risk? Seriously, even though the talking heads want to stress oil as a “weak dollar” play, there’s a host of reasons for oil price speculation, and oil was $20/bbl not too many years ago, so I can’t buy that dollar strength against other currencies is a primary mover of oil – or even a secondary mover. Tertiary at best, IMO. The dollar being worth half as much in exchange would have moved oil from $20 to $40, right? So where’s the other $80 of movement coming from? This is the same issue that goldbugs have with gold, they need to remember that gold and oil are speculative issues and will move for a variety of reasons, even including simple “animal spirits.”
The Fed changes the weights on their Trade-Weighted Dollar Index regularly, based on the latest trade numbers. It’s a dynamic index that always reflects trade weighting, see the Fed’s release on weighting for this data.
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[…] Bill Rempel (NO DooDahs!) posted a great piece on the Dollar Index and how useful it is as any kind of indicator of Dollar strength (or the lack there of). I’ve been waiting for someone to hit on the reality of the U.S. trade picture, as opposed to the way the USDX is calculated. Bookmark to: […]