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Don’t be confused with the USDX and the Trade-Weighted dollar index; they are not the same.
This lesson will introduce you to the new (and, as per the US FED, the more accurate USD representation) US dollar index.
The Trade-Weighted dollar index (also known as the “Nominal Broad-Dollar Index”) was created by the US Federal Reserve Bank to provide a more accurate representation of the USD strength compared to other foreign currencies.
Basically, the basis of being strong is having competitive goods compared to other countries' goods.
The TWD Index is calculated by taking the weighted average of bilateral exchange rates between the domestic currency and the currencies of major trading partners. The weights assigned to each currency are based on the relative importance of each trading partner in the country's total trade.
More accurate? Well, that’s how the Fed sees it. But before we dive into that, let’s first review the concept of the USDX;
Noticed how the USDX has a broad scope in considering which currencies to include in the USDX basket? Well, the key difference between the USD and Trade-Weighted Dollar Index is that the latter limits its weight calculation to USD competitive trading partners.
The Fed viewed the broad index as a more accurate representation of the dollar’s value against its currency trading partners.
Due to its positioning, the Nominal Broad-Dollar Index became famous among policymakers, economists and currency watchers/analysts.
The weighting in this index is at follows:
Remember: Unlike what ICE does to USDX, the US Fed annually adjusts the weighting in the Trade-Weighted US Dollar Index to reflect trading activity changes.
The Trade-Weighted Dollar Index was first calculated by the Fed in 1998. It was established to address the implementation of the Euro, a union of European countries in using one currency.
The implementation of the euro had caused the previous version of Trade-Weighted dollar index to lose currencies in the basket. The Fed then selected 26 currencies to use in this index, replacing the 11 currencies that get affected from the European Union (EU).
As mentioned, the Fed provides weighted averages of the forex value of the USD against the currencies of US’ major trading partners.
In the forex market, the Trade Weighted Dollar provides traders with valuable insights into the relative strength or weakness of the US dollar in economy and financial markets.
Essentially, here what Trade Weighted Dollar index provide for the forex market:
A rising TWD indicates that the US dollar is strengthening against the currencies of its trading partners.
This could suggest that US goods and services are becoming more expensive for foreign buyers, potentially impacting US exporters' competitiveness in international markets.
A falling TWD may indicate that the US dollar is weakening against other currencies, potentially leading to imported inflation as the cost of foreign goods and services rises for US consumers.
Traders may use this information to anticipate potential changes in inflation rates and adjust their investment strategies accordingly.
Changes in the TWD can influence trade balances by affecting the cost of imports and exports. For example, a stronger US dollar may lead to a higher trade deficit as US exports become more expensive for foreign buyers while imports become cheaper for US consumers.
Traders may analyze TWD movements to assess potential impacts on trade balances and adjust their trading strategies accordingly.
For the next lesson, you’ll dive into the concept of the Bloomberg Dollar Spot Index.