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April 7, 2010

Dollar Index Minus the Euro

We took a look yesterday at how the perceived dollar rally out of December was not a rally at all, but rather a strengthening of the dollar versus other trash. In real terms... that is against commodities and the currencies of commodity-based economies... the buck has been sinking. The generally accepted explanation for the rally in the DX is the weakening of the euro, so out of curiosity, I decided to see just how much of an effect the euro has had on the DX since the rally began. The result is quite surprising.

I began by obtaining the formula for calculating the dollar index. Each currency in the index has a geometric weight, and then a multiplier is applied to the sum. Therefore, backing the euro out of the index was a simple feat. I then re-indexed the new price series so that the original DX and the euro-adjusted DX would have the same value on November 30, 2009. Here is the result:

dollar index without the euro

As you can see, if the euro were not part of the DX, the index would have rallied even more since early December. Now keep in mind there are some tricks of math here since the currencies are geometrically-weighted into the index. The euro, in absolute terms, has still provided for most of the rally out of December. The point here is that the rally has not been the sole product of euro weakness. In fact, the next two components of the DX by size, the Japanese Yen and British Pound, have both performed more poorly than the euro, and both Britain and Japan are are on the currency offenders list. You can see once again why I believe precious metals could soar in dollar terms, even as the DX climbs.


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