Why USD-Index not reliable

18/3/2010

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.

Will Gold and Silver Investors Ever Get a Tax Overhaul?

With tax time right around the corner, investors of all types are preparing their finances to determine their final tax burden. While some investors are paying as little as 15% on their capital gains, precious metals investors are stuck paying 28% – but perhaps not for long.

Capital Gains Taxation

In the United States, long term capital gains taxes come in at just 15%, well under ordinary income tax rates. Unfortunately, the US government refuses to recognize gold and silver as similar investments, choosing to relegate them as “collectibles” and stamping a hefty 28% charge on any potential profits.

However, as precious metals investing becomes more popular, this once small group of investors is gaining weight with Congress. In recent years, many new resolutions to declare silver and gold an investment rather than a collectable have come before Congress.

An Unlikely Helper

Although physical bullion and exchange-traded funds compete directly with each other for investment dollars, exchange-traded fund companies are helping to lead the charge against unfair tax treatment. Even ETFs – which trade like stocks, pay dividends like stocks, and are bought and sold like stocks – are subject to the collectible tax rate of 28% if they hold certain commodities, mostly precious metals.

Of course, these companies have a stake in retaining their clients, and they have become leaders in a fight against unfair tax treatment.

Luckily for individual investors without the weight and pull of multi-billion dollar businesses, banks are also some of the biggest lobbyists in the nation, and they too have the ability to help the taxation lot of precious metals.

The Time is Now

With gold and silver prices making the nightly news alongside indexes like the Dow Jones and Nasdaq, now is a better time than ever for real tax reform and fair treatment for silver and gold investors.

Although a higher tax rate is unlikely to scare anyone away from the huge benefits of gold and silver, it would be a benefit for investors to receive the same tax treatment when they decide to cash in their earnings. Seeing as tax credits and fair taxing solutions are on the top of voters’ wish lists, and with the previous bill earning 15 cosponsors in the Senate, silver and gold investors are very much on their way to fair treatment.

Taxes Aside

Even with unfair taxing schemes by the federal government, the advantages of gold and silver as a store of wealth are not lost. Throughout history, these two metals have prevailed through every financial meltdown, depression, war and famine to emerge as the best currency.

Though Uncle Sam may not appreciate your wise financial decision to buy metals and hedge your assets, you're doing the right thing. And as the political winds shift from left to right, pro-government to anti-government and everything in between, precious metals investors should be assured that they're on their way to one of the biggest tax overhauls in history. When real money is taxed fairly, expect a whole new movement into precious metals as currency.

Dr. Jeff Lewis