-- Posted 17 March, 2010 | | Discuss This Article - Comments:

Often thrown around as the end-all solution for tracking the value of the US dollar, the dollar index is one of the poorest indicators for the true performance of the currency itself.  Silver investors who pay heed to the dollar index will certainly be led astray, as there are fundamental reasons why the index simply is not accurate. 

Understanding the Dollar Index

The US dollar index tracks the daily price of the US dollar against a basket of world currencies.  By doing so, it provides a very simple and basic indicator to track the change of the dollar's value without complicated futures contracts and foreign exchange contracts.  All told, it is a very easy way to track the value of the US dollar, but only against the value of other currencies.

Why the Index Fails

The reason the US dollar index isn't a good indicator is due to the way it is calculated.  The index itself is made up of only six currencies, which represent 20 nations.  The Euro, Yen, Pound, Canadian Dollar, Kronas and Francs are all included in the index. 

As you can see from the list itself, the dollar index is relatively undiversified, even though it includes all the major currency pairs.  However, it’s also flawed in that it tracks the value of a fiat currency against many other fiat currencies. 

Thus, for the sake of discussion, if the US dollar were to lose half its value while the six major currencies in the index also lost half their value, the US dollar index wouldn't move at all.  

Ignore the Index

Of the six included currencies, virtually all are represented by central banks that employ essentially the same monetary policy with a few minor exceptions.  The European central bank is perhaps slightly “tighter” with monetary policy, as is the Swiss bank; however, the remaining four are practically all in bed with one another.  That is, if one nation is inflating, you can count on the others to do the same.  Most of this is conducted in the guise of protecting international trade, but often it’s done to devalue the debt that each of these nations owes to others.

Case in Point

To 2002 to 2010, the dollar index plunged from 120 to 80, a change of -33%.  However, during that time period, real money – namely, gold and silver – rose by nearly 400%.  This is due to the fact that fiat currencies fell equally to gold and silver, with the US dollar losing slightly more ground than the average of the other six components. 

If you were to look at the US dollar index and ignore the price of gold and silver, you would think that gold and silver had risen 33%, while the US dollar had fallen 33% – which we know is completely inaccurate. 

An Important Component of Precious Metals Investing

Although we often hear the media and prominent investors suggest gold and silver are purely hedges to the US dollar, they're also hedges to every other fiat currency around the globe.  This is an important point often lost on new investors: their real money holdings of gold and silver aren't just anti-dollar, but they're anti-fiat.

Dr. Jeffrey Lewis

www.silver-coin-investor.com