FOREIGN EXCHANGE
AUGUST 30, 2011.
Popular Dollar Index Misses Major Shifts in Value .
by STEPHEN L. BERNARD
Reuters
Because the world was so different nearly four decades ago—emerging markets weren't nearly as important and euro-zone countries accounted for a larger share of world trade—the Index's composition makes it something of a relic.
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The yen has consistently flirted with historic highs against the U.S. dollar the past month. The Swiss franc has repeatedly reached new all-time peaks against the greenback in the same time span. But look at IntercontinentalExchange Inc.'s U.S. Dollar Index, a metric seen as a proxy for the dollar's global worth, and you'd have no idea.
The increasingly popular U.S. Dollar Index hasn't been adjusted in 12 years. That means the way ICE weights the dollar against six other currencies is outdated.
It considers Sweden to be one of the U.S.'s top trading partners and includes the krona in the index, but it doesn't include the Chinese yuan. More important, movement in the euro-dollar exchange rate makes up 58% of the index's basket even though actual exchanges between euro-zone countries and the U.S. make up just 13.3% of U.S. international trade.
While some foreign-exchange traders know that the index takes into account only six currencies, a Dow Jones analysis shows it usually moves significantly only when the euro-dollar exchange rate does, making it a proxy for one currency pair rather than a true measure of the dollar's broad value.
The problem is amplified at times like now, when the euro is stuck in a narrow trading range against the dollar, but the dollar is swinging wildly against the yen and Swiss franc, which have more modest weightings.
Ray McKenzie, IntercontinentalExchange's vice president of U.S. marketing and sales, says there's "no such thing as a perfect benchmark," but says ICE's index is "the best" there is. He said transparency in the way it's calculated and the ability to track it in real time are both major advantages.
The U.S. Dollar Index was created by the Federal Reserve in 1973, after the Bretton Woods agreement ended, and was meant to be a trade-weighted average of the dollar's value as it freely floated against other currencies. It originally weighed the dollar against a basket of 10 currencies, and ICE started offering futures contracts based on the Fed's index in 1985. The basket was slimmed down to its current version when the common euro-zone currency was introduced in 1999. ICE has held on to the Fed's original model since it was created, and points to the Fed connection as one of the advantages, even though the central bank abandoned it for a newer version in 1998.
Mr. McKenzie said ICE has no plans to adjust the way the Index is weighted.
"The distortions in the formula have become apparent," says Philip Guarino, president of Boston-based Elementi Consulting, which provides currency-issue consulting services for international businesses. "It's an easy summary of something, but a wrong summary."
Because the world was so different nearly four decades ago—emerging markets weren't nearly as important and euro-zone countries accounted for a larger share of world trade—the Index's composition makes it something of a relic.
Dow Jones's analysis shows the overweighting toward the euro is the most-obvious issue. There hasn't been a single day this year that the 30-day average correlation between the euro-dollar exchange rate and the Index has been weaker than negative 0.7—that's on a scale where negative 1.0 represents a perfect indirect relationship, meaning two objects move in exact opposite directions. In fact, since the current version of the Index was first introduced, there have been only 20 days when the correlation was weaker than negative 0.7.
On Aug. 18, for example, the Index rose 0.76%, similar to the euro-dollar exchange rate move of 0.65%. But the dollar jumped 0.98% against the Canadian dollar, 1.55% against the Australian dollar and 0.52% against the Swiss franc, all highly traded currencies. It fell 0.04% against the yen and 0.05% against the yuan.
"It makes me crazy," said Rebecca Patterson, chief markets strategist at J.P. Morgan Asset Management. "It's so inaccurate."
The company said "the weightings of the (Index) component currencies are long-established and well-understood by market participants."
The contract's high trading volume allows people to easily trade contracts to make bets on broad dollar movements, Mr. McKenzie said. As foreign-exchange trading gained widespread popularity the past several years, Index trading volumes at ICE have soared from 6,000 daily contracts to more than 40,000.
ICE collects $1.35 per contract traded by non-members and $0.24 for contract traded by members. If Index trading were broken down evenly between members and non-members, current Index trading would generate about $8 million annually. That's a tiny fraction of ICE's overall revenue but one that is likely to continue growing quickly.
Mr. McKenzie said the Index's increasing market-wide recognition is building upon itself.
In fact, one of the reasons it's so difficult for competitors to gain a foothold in the dollar index field is because ICE's Index is already so widely considered as a benchmark. (News Corp.'s Dow Jones & Co., which owns The Wall Street Journal, is a minority owner of the Dow Jones FXCM Dollar Index that was launched earlier this year.)
Nick Bennenbroek, head of currency strategy at Wells Fargo in New York, acknowledged the Index's weaknesses but said it's still a convenient way to measure the dollar's strength because it can be used to get a rough picture of how the dollar fares against the most-liquid currencies in the foreign-exchange market.
Some investors who like the idea of using a dollar index but don't want to use ICE's measure watch the Federal Reserve's broad-dollar index, a metric that takes into account 26 currencies and also is updated annually to reflect up-to-date international trade data. The correlation between that measure and the euro-dollar exchange rate has been weaker than the -0.7 mark on 43 days this year.
J.P. Morgan created its own fund in 2007 that tracks the movement of the Fed's broad dollar index in order to give clients the ability to access an investment that is impacted by the dollar's wide-ranging value against its trading partners.
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