The U.S. Dollar Index: A Deceptive Indicator of USD Strength

Most of the major financial news outlets and many investors have come to rely on the movements of the U.S. Dollar Index as a daily barometer of the U.S. dollar’s relative strength and weakness taking it on faith that the Dollar Index is the dollar – pure and simple. In reality, the Index offers a very distortive view of the movement of the dollar against the currencies that matter most. If anything, recent movements of the Index are a reflection of euro weakness rather than dollar strength. Words: 1019

Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com, provides below further reformatted and edited excerpts from Andrew Schiff’s (www.europac.net) original article* for the sake of clarity and brevity to ensure a fast and easy read. Schiff goes on to say:

The U.S. Dollar Index
- a basket of six non-dollar countries/currency areas. Here is how the weighting breaks down:

Eurozone 57.6%
Japan 13.6%
UK 11.9%
Canada 9.1%
Sweden 4.2%
Switzerland 3.6%

As you can see, the top three currencies account for more than 83% of the total composition, with the euro alone taking up more than half of the Index. Meanwhile, the eurozone only accounts for some 25% of non-US Gross World Product (GWP). The reason for this discrepancy is that the Index has not been rebalanced since its creation in 1973, when the “euro” portion was made up of the strong and separate currencies of West Germany, France, Italy, the Netherlands, and Belgium.

Recommended Country/Zone Asset Allocation
We continue to recommend investments in non-dollar assets because we feel that the US government is pursuing policies that will ultimately destroy the value of our currency. Logically, we also avoid investing in foreign countries following the same path. Given that all politicians and central bankers are subject to the same inflationary temptations we have selected those countries that have shown the strongest monetary self-control – otherwise, we would be jumping from the frying pan straight into a fire – as per the following allocations:

Hong Kong 20.8%
Eurozone 17.8%
Canada 15.3%
Singapore 13.5%
Australia 11.1%
Norway 8.5%
Switzerland 6.0%
Brazil 4.2%
Japan 3.0%

The noticeable differences in our allocation from that of the Dollar Index are the absence of the UK pound and the much lighter exposure to the euro and the much higher exposure we give to currencies from the “resource economies” of Australia, Canada, Norway, and Brazil, as well as our significant holdings in the Asian mercantile city-states of Hong Kong and Singapore. We are also notable in our light exposure to Japan, which has pursued programs of artificial stimulus and ‘quantitative easing’ like those of the United States.

How the U.S. Dollar Index and Our Asset Allocation Performances Compare
The different weightings translate into very different outcomes over the long haul. For instance, in the two years between May 1, 2008 and April 15, 2010, the currencies in the U.S. Dollar Index (in the same weightings as in the Index) fell by 8.9% against the dollar. By contrast, over the same time frame, the investment in the regions we have selected (in the weightings listed above) fell by only 4.2%. This is not a trifling sum.

Why Our Recommended Asset Allocation Has Outperformed
There are empirical reasons to explain the divergence. We have long felt that the European Union would one day come under intense conflict between its monetary union and the political independence of its member states. As a result, we have always been somewhat wary of euro-denominated investments.

The Greek debt drama has placed those tensions on vivid display. After months of tough talk from fiscally responsible Germany, the EU has recently yielded, pledging close to $1 trillion to bailout Greece and, in the process, giving a tacit guarantee to the debt of its other weak member-states. The bailout signifies Brussels’ decision to parrot Washington’s policy of “monetization” of bad debt. They are choosing inflation over default, paving the way for the euro and dollar to devalue contemporaneously – rendering the Dollar Index a deceptive indicator.

Meanwhile, the debt problems currently surfacing in the US exist in the UK to an even larger degree. As a result, the pound sterling, which does not have a reserve currency advantage like the US dollar, has been one of the weakest major currencies of the last few years. Despite the problems with the euro and the pound, we have nevertheless maintained an attraction to European investment overall. The continent retains strong trade balances, high productivity, globally competitive companies, and high savings rates.

The Royal Bank of Canada ranks all countries by what it terms “Sovereign Debt Risk,” which is the likelihood that a country will be unable to repay its debts. In calculating its index, the bank looks at a country’s debt and government spending obligations as a percentage of its GDP, as well as other factors such as current account surplus or deficit, foreign exchange reserves, net external debt, real GDP growth, and inflation.

Among the major countries that the bank tracks, some of the best performers (least likely to default) are Norway, Switzerland, Australia, New Zealand, and Canada. Some of the poorer performers (most likely to default) are EU members (Greece, Portugal Ireland, and Italy), Britain, and Japan.

Gold is a Much Better Indicator of Currency Strength than U.S. Dollar Index
It should be no surprise that fiscal and monetary discipline translate into currency strength and while the US dollar has recently done well against the Dollar Index, we have demonstrated that this is really a hollow accomplishment.

When measured against gold, a much better arbiter of currency strength, the dollar has fared decidedly poorer.

*http://www.europac.net/newsletter/newsletter23.htm#guest (The opinions provided in this article are not intended as individual investment advice and are only those of the writer. Past performance is no guarantee of future results.)

Editor’s Note:
- The above article consists of reformatted edited excerpts from the original for the sake of brevity, clarity and to ensure a fast and easy read. The author’s views and conclusions are unaltered.
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