I will present a case against the consensus regarding the US Dollar rally we have seen from Q4 2009 to Q1 2010. The best starting point for this analysis will be to first define what we mean by dollar strength/weakness as well as de-constructing the most commonly used measuring stick.
- The USDX is a benchmark index comprised of a basket of currencies to which the Dollar is measured against. Dollar strength is perceived to be when this index rises and vice versa.
As I write this, the current basket of currencies and the weights applied are as follows:
| Euro | 57.6 % |
| Japan/yen | 13.6 % |
| UK/pound | 11.9 % |
| Canada/dollar | 9.1 % |
| Sweden/krona | 4.2 % |
| Switzerland/franc | 3.6 % |
Does anything standout as peculiar in the composition of this basket? Well three very flawed currencies make up 73.1% of the Index. With this basket as the benchmark, did a temporary rally in the dollar really occur? The Euro has been beaten down for the Greece issue and the very dangerous precedent they set by "indirectly" funneling bailout money through the IMF. The GBP is very flawed and has a reasonable correlation with the Euro in addition to being bankrupt. So what I'm trying to get as is, why in the world would you measure a currency against a benchmarked index comprised of the most unsound/weakest currencies in the world? I contend the index should be composed of the most fundamentally sound currencies as it will paint a more clear, albeit not perfect picture, that is far more representative of reality. I'm the first one to admit you can't really measure currency strength/weakness barring Gold and/or Silver as benchmarks, but having a sound currency dollar index - SCDX, may be worth considering if nothing else but to qualify whether it deserves any merit.
I have composed a basket of six currencies, which I think are the most sound. This obviously can be debated whether or not this is optimal, but by incorporating qualitative analysis regarding the monetary and fiscal policy, some stand out from the crowd. For example, one currency in the basket is the AUD due to being one of the very few that have risen interest rates on a continual basis (now up to 4.25%, with the minutes indicating they will continue down this path) This index, measured over a one year period (ending April 5, 2010), shows some interesting things.
- The SCDX declined 13.44% with Gold increasing about 21% (which has some distortions due to the time it took for commodity prices to rebound to levels reflecting the true market value following the financial crisis.
- The Correlation or inverse correlation between the USD and Gold, as you can see, is very strong. When Gold peaked the SCDX was at 1.85, which you can draw three possible conclusions from : The significantly reduced correlation is a result of A) Investment demand, B) Speculators - which turned out to be the case at least in part or C) this index isn't a good barometer.
- I would go with a combination of A and B, at least relatively speaking. The chart below essentially says when the USD declines against this basket of currencies, gold goes up in a similar fashion.
- The USDX on the other hand doesn't have nearly the correlation as the SCDX. While it might appear gold has been rallying despite a rising dollar, I have two contentions. 1) The dollar has been more or less bottom bouncing for most of 2010. 2) Increased Investment demand has been the driving force behind gold's surge from the 2010 lows to the current price.
- I'm not saying this will turn out to be the measure out there, just far better than the USDX.
Some currencies included in the SCDX are the AUD, SGD & NOK
click to enlarge 
Disclosure: Long AUD, NOK, SGD, Short: EUR
