As U.S. investors continue to diversify their equity and bond holdings into markets around the world, they are beginning to realize that the value of foreign currencies against the U.S. dollar can have a significant impact on the total return of their investments.

As a result, the links between trade and currency values are becoming increasingly important in the global economy. For these reasons, tracking the value of the U.S. dollar can be of paramount concern for global money managers. However, on any given day, the value of the dollar may increase against some currencies but decline against others. So what is a dollar actually worth?

In 1973, the Federal Reserve (Fed) sought to create an index that tracks the value of the U.S. dollar against a basket of foreign currencies, selected and weighted based on the United States’ largest trading partners at the time. Before the advent of one-click access to international financial markets, the value of the currency was seen as a significant factor impacting the competitiveness of trade.

Although the only change to the original U.S. Dollar Index occurred after a number of individual European currencies were combined to form the euro, the Federal Reserve created a series of indexes in the late 1990s that sought to create broader, trade-weighted measures of the dollar. In this regard, the Fed had evolved its thinking about how the value of the dollar should be tracked. Today, in our view, both trade and markets define the value and role of the dollar in the global economy.

Its value continues to evolve with new economic relationships and changing market dynamics. Compared to the U.S. Dollar Index (DXY), capturing the value of the dollar against its primary trading partners alone diminishes the impact of capital flows in defining short-term foreign exchange (fx) movements. Balancing the relative impact of trade flows and portfolio flows may provide a truer sense of the value of the dollar in response to short-term movements and longer-term trends.

An Evolving Index for a Changing World

For many market participants and researchers, the U.S. Dollar Index was one of the most common metrics for assessing the value of the dollar against a basket of foreign currencies. But its inflexible methodology is hopelessly stuck in the 1970s. In many ways, this static methodology doesn’t seem very reflective of the realities of the current global economy. In 1973, the currencies in the basket contributed over 40% of the global output; today, that number is only 27%. In fact, some of America’s largest trading partners—such as China or Mexico—and some of the most liquid currencies in the world—such as the Australian dollar or the Korean won—do not appear in the Dollar Index at all.