Correction Looming In The US Dollar But The DXY Index Still Waiting On The Memo

|
Includes: FORX, FXC, UDN, USDU, UUP
by: Michael Golembesky

Summary

The US Dollar as measured by the DXY Index is too heavily weighed down by European Currency Pairs, which make up over 77% of the index as a whole.

This over-weighting of European Currency pairs causes questionable patterns to appear during times when the index is moving in opposition to that of the larger trend.

The US Federal Reserve Board has created alternate US Dollar Indexes that are weighted by the trade conducted between the United States and other world countries.

These alternate indexes can help provide clarity to direction of the US Dollar and many of the component pairs at major inflection points when the pattern on the DXY index.

Using this method of analysis can be compared to that of looking at multiple equity indexes to help confirm patterns during major inflection points.

The US Dollar as measured by the DXY index has been in a very messy consolidation pattern since the March 2015 high. This move down from this high has provided us with a very ugly complex corrective pattern with the move up off of the August lows equally as ugly as the move down from the March highs. This has left us scratching our heads during much of this move having us ask whether we will be re-visiting the August lows or if in fact we are ready to break out over the March highs.

Even now as we are within striking distance from the March highs the pattern off of the August 24th low is still less than ideal and does leave us questioning if we are ready to breakout or is there something else going under the surface of the DXY Index.

Before we attempt to answer these questions let's take step back and breakdown what the DXY index is actually measuring. The DXY is a composite index that is made up of 6 different currency pairs. These 6 currency pairs are the Euro vs. US Dollar, Japanese Yen vs. US Dollar, British Pound Sterling vs. US Dollar, Canadian Dollar vs. US Dollar, Swiss Franc vs. US Dollar & Swedish Krona vs. US Dollar. Of these 6 currency pairs the Euro makes up 57% of the entire index with another 20% comprised of other European currency pairs (British Pound Sterling, Swiss Franc, and Swedish Krona). The Japanese Yen and the Canadian Dollar make up the rest of the index with a combined weighting of 23%.

The only Asian currency pair that is represented in the DXY index is the Japanese Yen and even though the Australian Dollar is the fourth most heavily traded currency pair in the world today it is not represented in the DXY Index at all. Also not represented in the DXY Index are any emerging economies such as China, Mexico, Korea or Russia. So while the DXY index does certainly measure the strength of the US Dollar against foreign currencies it is very much overweight in European Currencies and is very dated given the changing world economics in the past two decades.

The chart above shows the currencies that are represented in the DXY Index and their respective weights within the index.The chart above shows the currencies that are represented in the DXY Index and their respective weights within the index.

So the question is would the US Dollar have a different look if we had an Index that included a broader selection of currency pairs that were weighted to better reflect the usage of the currency pairs as they trade around the world in relation the U.S. Dollar. Would this type of index tell us anything different than that in which we are seeing with the DXY that is very much overweight in European currency pairs?

As it happens the US Federal Reserve Bank saw this same issue with the DXY index and created three new US Dollar indexes in an attempt to better gauge on the true value of the US Dollar. The Federal Reserve Bank has categorized these indexes into the broad currencies index, the major currencies index, and the other important trading partners (OITP) index.

Unlike the DXY which has a fixed weighting that has not changed over the years The Federal Reserve Bank updates the weighting of these three indexes annually to reflect the trade that is exchanged with each of the countries within these indexes and the United States. These indexes are therefore named the "Trade Weighted US Dollar Indexes".

The Broad Currencies Index is composed of 26 currencies around the world which includes all of the countries that are currently using the Euro as a single currency. As of 2014 China conducts the most with the United States with the Euro Area coming in second place. Canada and Mexico are not far behind the Euro Area in third and fourth place respectively.

The Major Currencies Index is composed of 7 currencies around the world and includes some of the most heavily traded and liquid currencies around the world. This index includes all of the currencies that are included in the DXY index but has added the Australian Dollar which is now the 4th most actively traded currency in the Forex Markets. Of course the weighting of the Major Currencies index is quite different from that of the DXY as it is based on the actual trade that is transacted between the United States and the various countries/regions with in the index.

The Other Important Trading Partners Index is simply an index of all of the currencies that are NOT in the Major Currencies index

The chart above shows the trade weights for the currencies that are currently represented in the index. The pairs that are in the Major Currencies Index are represented by the dark blue bars.

If we look at just the trade weighted major currency pairs index and compare it to the DXY index we can see that the DXY is quite out of date when it comes to its weighting. As is visible in the chart below while the Euro area currencies represent less than 40% of the trade volume it still represents over 57% of the weight in the DXY Index. Also of note in the chart is the Average Daily Trade Volume as is represented by the grey bars. As is visible the Euro only accounts for 24% of the total trade volume of all currencies but again still represents 57% of the total DXY index. More egregious is that the Australian Dollar which accounts for close to 7% of all trade volume and is the 4th most actively traded currency is not represented in the DXY Index whatsoever.

The chart above shows the weight of the DXY Index (orange), the trade weighted index (NASDAQ:BLUE) and the average daily trade volume (as of 2014) in the FX markets (grey).

So either way that we look at it, from a trade weighting perspective or from a transactional volume perspective the DXY much too heavily weighed down by European currencies and the Euro vs. US Dollar currency pair in particular.

So now that we have reviewed the various ways to view the US Dollar we can move on to reviewing and comparing the charts to see if viewing the data through the differing data sets will help us determine which direction the US Dollar is headed in the future or perhaps even give us an idea as to which individual currency pairs will be moving in the weeks and months ahead?

First let's take a look at the three indexes in chart plotted in chart format. The first chart is the DXY Index, followed by the Federal Reserve Board's Trade Weighted US Dollar Index: Major Currencies and the third is the Federal Reserve Board's Trade Weighted US Dollar Index: Broad Currencies. Looking at all of these chart we can see that we are still in a very strong up trend that began with the 2011 low. With the heart of the move occurring in 2014.

The chart above is composed of the 6 currency pairs that are contained in the U.S. Dollar Index Known as the DXY. These currency pairs are from the; Euro Area, Japan, United Kingdom, Sweden and Switzerland. This index has a fixed weighting system with the EUR/USD currency pair representing 57.6% of the entire index.

The chart above is composed of the 7 currency pairs that are contained within the Trade Weighted U.S. Dollar Index: Major Currencies. These currency pairs are from the; Euro Area, Japan, United Kingdom, Switzerland, Australia and Sweden. This index is weighted by the amount of trade conducted between these countries and the United States.

The chart above is composed of currency pairs of the 26 countries in which the United States conduct the vast majority of its trade with. These countries are; The Euro Area, Japan, United Kingdom, Switzerland, Australia, Sweden China, Mexico, Korea, Taiwan, Brazil, India, Singapore, Thailand, Russia, Hong Kong, Israel, Indonesia, Saudi Arabia, Chile, Colombia, Philippines, Argentina and Venezuela. This index is weighted by the amount of trade conducted between these countries and the United States.

There are a couple of things that stand out quite clearly when we look at these three index charts. The first thing we notice on the DXY index chart is that the retracement that ended in May of 2014 was extremely deep. So deep in fact that it almost breached the previous low that occurred in September of 2012. Conversely neither of the Trade Weighted US Dollar Indexes showed this same deep retracement in May of 2014. So if the only index that had such a deep retrace was the DXY Index, which is so heavily weighed down by the European currency pairs the question is; were the European currency pairs the cause of this deep retrace?

We can answer this question by examining the currencies of the DXY during move that began with the high in May of 2013 and ended with the low in May of 2014. By examining the relative change of all of the currency pairs that make up the DXY index we can clearly see that it was in fact the strong moves that were occurring by the EUR/USD, GBP/USD and USD/CHF that caused the deep retracement in the DXY chart that was not seen in the other two Dollar Indexes. During this same time period the USD/CAD and USD/JPY had already begun moving higher showing heavy divergence with the DXY index itself. In fact the USD/CAD moved up over 8% while the DXY Index moved down 3% over the same time period. The movement of DXY component currency pairs is shown visually in the graphic below.

The graphic above shows data from the time period starting with the high that occurred in May of 2013 and the low that occurred in May of 2014. The top table simply shows the change of each of the currency pairs that make up the DXY Index along with the change in pips and percentage points. The third column shows the effect that the currency pair had to the index during that time period, either positively or negatively and the fourth column shows what the weight should be relative to the index. The fifth column on the graphic shows the relative performance of each of the currency pairs in relation to the DXY index. The radar charts are simply graphical representations of the data in the table above.

As mentioned earlier once we did finally bottom the result was the same across all of the index charts and that of course was a parabolic rally that continued until into the spring of 2015. Interestingly during this rally there was no divergence with any of the DXY component currency pairs as they all moved with the DXY index. Even the effect that each of the currency pairs had to the DXY index during this rally was remarkably close to what the actual weighting should have been. The notable under performer of the group was the USD/CAD. This of course is not entirely surprising given that this pair had outperformed the index by close to three fold in the year prior to the parabolic rise in the DXY index as a whole.

The graphic above shows data from the time period starting with the low that occurred in May of 2014 and the high that occurred in March of 2015. This period marked a parabolic rally in the DXY Index in which the Index gained close to 23% in value.

Now all of this leads us to what is next for the US Dollar over the coming weeks, months and years. Does any of this information help guide us in forecasting the direction of the US Dollar or any of the individual component pairs that make up any of the US Dollar Indexes?

Again comparing the three US Dollar Index charts the most striking difference between the DXY Index and the other two indexes is that fact that the DXY has still yet to make a new high over the March 2015 high whereas both of the Trade Weighted indexes have made new highs over the March 2015 high. This difference is once again being caused by the fact that the Euro is overweight in the DXY Index.

In fact if we look at the chart of the EUR/USD we see a very similar inverse pattern to that of the DXY where the EUR/USD has yet to make a new low below the March 2015 low. The incomplete pattern on both the DXY and the Trade Weighted Major Pairs Index is suggesting that we still have some unfinished business to the upside however both of these charts do suggest that we will see a corrective move lower prior to attacking new highs. This viewpoint is also supported in many of the currency pairs that are components of both of these indexes.

Another interesting point is that the Trade Weighted Broad Currencies Index has a much more completed pattern in place than both the DXY Index and the Trade Weighted Major Currencies Index. Suggesting that this index may not see a shallow retrace prior to moving higher, but rather the next local high made on this index may in fact be a much more significant top.

Now if we use the third Federal Reserve Bank's US Dollar Index chart which is the Trade Weighted US Dollar Index: Other Important Trading Partners (OITP) (which again is all of the currency pairs that are NOT in the Major pairs) index we can see that the US Dollar against these currency pairs is still in the heart of very strong move higher. This suggests that this index will likely still see higher levels without seeing much of a retrace prior to forming a larger degree top. This view is also being reflected on the charts of many of the component pairs that make up this index that we also track.

The chart above shows the 19 currency pairs that are NOT contained within the Trade Weighted U.S. Dollar Index: Major Currencies. China, Mexico, Korea, Taiwan, Brazil, India, Singapore, Thailand, Russia, Hong Kong, Israel, Indonesia, Saudi Arabia, Chile, Colombia, Philippines, Argentina and Venezuela. This index is weighted by the amount of trade conducted between these countries and the United States.

So by looking at the U.S Dollar using differing sets of data the fog that is currently the DXY index begins to lift and we start to see a much more clear picture of what is likely in store for not only the U.S. Dollar but many of the component currency pairs that make up each of these various Dollar Indexes.

So after reviewing the data that is available in all of these various U.S. Dollar Indexes we can surmise the following:

· The US Dollar is likely close to a correction that will likely last into the early part of 2016

· This correction will likely cause an 8% to 12% drop in value of the US Dollar

· Prior the larger correction there will likely be a nominal new high made by the US Dollar

· There will be many excellent trading opportunities that will come to light in the component currency pairs of all of these U.S. Dollar Indexes.

I hope you took note of this last bullet point as it is really the most important point of this entire article!

In the next article we will delve into the opportunities and trade setups that are being presented in the component currency pairs and which analyzing these various U.S. Dollar Indexes has helped brought out to the surface.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Although I have no direct position in the DXY Index however I am net Short the U.S. Dollar through various currency pairs.