What Is the U.S. Dollar Index (USDX) and How to Trade It

What Is the U.S. Dollar Index (USDX)?

The U.S. dollar index (USDX) is a measure of the value of the U.S. dollar relative to a basket of foreign currencies. The USDX was established by the U.S. Federal Reserve in 1973 after the dissolution of the Bretton Woods Agreement. It is now maintained by ICE Data Indices, a subsidiary of the Intercontinental Exchange (ICE).

The six currencies included in the USDX are often referred to as America's most significant trading partners, but the index has only been updated once: in 1999 when the euro replaced the German mark, French franc, Italian lira, Dutch guilder, and Belgian franc. Consequently, the index does not accurately reflect present-day U.S. trade.

Understanding the U.S. Dollar Index (USDX)

The index is currently calculated by factoring in the exchange rates of six foreign currencies, which include the euro (EUR), Japanese yen (JPY), Canadian dollar (CAD), British pound (GBP), Swedish krona (SEK), and Swiss franc (CHF).

The euro is, by far, the largest component of the index, making up 57.6% of the basket. The weights of the rest of the currencies in the index are JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), and CHF (3.6%).

The index started in 1973 with a base of 100, and values since then are relative to this base. It was established shortly after the Bretton Woods Agreement was dissolved. As part of the agreement, participating countries settled their balances in U.S. dollars (which was used as the reserve currency), while the USD was fully convertible to gold at a rate of $35/ounce. 

An overvaluation of the USD led to concerns over the exchange rates and their link to the way in which gold was priced. President Richard Nixon decided to temporarily suspend the gold standard, at which point other countries were able to choose any exchange agreement other than the price of gold. In 1973, many foreign governments chose to let their currency rates float, putting an end to the agreement.

History of the U.S. Dollar Index (USDX)

The U.S. Dollar Index has risen and fallen sharply throughout its history. It reached an all-time high in 1984 at nearly 165. Its all-time low was nearly 70 in 2007. Over the last several years, the U.S. dollar index has been relatively rangebound between 90 and 110.

The index is affected by macroeconomic factors, including inflation/deflation in the dollar and foreign currencies included in the comparable basket, as well as recessions and economic growth in those countries.

The contents of the basket of currencies have only been changed once since the index started when the euro replaced many European currencies previously in the index in 1999, such as Germany's predecessor currency, the Deutschemark.

In the coming years, it is likely currencies will be replaced as the index strives to represent major U.S. trading partners. It is likely in the future that currencies such as the Chinese yuan (CNY) and Mexican peso (MXN) will supplant other currencies in the index due to China and Mexico being major trading partners with the U.S.

Interpreting the USDX

An index value of 120 suggests that the U.S. dollar has appreciated 20% versus the basket of currencies over the time period in question. Simply put, if the USDX goes up, that means the U.S. dollar is gaining strength or value when compared to the other currencies.

Similarly, if the index is currently 80, falling 20 from its initial value, that implies that it has depreciated 20%. The appreciation and depreciation results are a factor of the time period in question.

How to Trade the USDX

The U.S. dollar index allows traders to monitor the value of the USD compared to a basket of select currencies in a single transaction. It also allows them to hedge their bets against any risks with respect to the dollar. It is possible to incorporate futures or options strategies on the USDX.

These financial products currently trade on the New York Board of Trade. Investors can use the index to hedge general currency moves or speculate. The index is also available indirectly as part of exchange-traded funds (ETFs) or mutual funds.

For instance, the Invesco DB U.S. Dollar Index Bullish Fund (UUP) is an ETF that tracks the changes in value of the US dollar via USDX future contracts. The Wisdom Tree Bloomberg U.S. Dollar Bullish Fund (USDU) is an actively-managed ETF that goes long the U.S. dollar against a basket of developed and emerging market currencies.

Invesco DB also offers its U.S. Dollar Index Bearish Fund (UDN), which shorts the dollar, gaining in value when the dollar weakens.

The Bottom Line

The U.S. Dollar Index (USDX) is a relative measure of the U.S. dollars (USD) strength against a basket of six influential currencies, including the Euro, Pound, Yen, Canadian Dollar, Swedish Korner, and Swiss Franc. The index was created in 1973, but remains useful to this day. The USDX can be used as a proxy for the health of the U.S. economy and traders can use it to speculate on the dollar's change in value or as a hedge against currency exposure elsewhere.