The Importance of the U.S. Dollar
To trade the currency markets implies to buy or sell different currency pairs with the purpose of making a profit. The profit is being made if the trader indicates the correct direction the currency pair is going to move. Having said that, if the trader sells a currency pair, the expectations are that the market will move lower, and by the time he/she is closing the trade, the difference between the selling price and the closing price represents the profit. That is, the profit before expenses! The net profit results from deducting the commission and spread fees, as well as negative swaps, if there is the case. When buying a currency pair, or when going long, the idea is to close the position from a higher level. The difference between buying price and the closing one represents the profit before expenses. When reading the explanation about how to make a profit on the Forex market, everything seems straightforward. And it is! However, it is not simple. There are many factors that make currency pairs moving aggressively on both sides, and most of the times the market is ranging. This means that upward moves are followed by strong moves in the opposite direction and the other way around is possible as well. Ranges are happening most of the times and trends or impulsive move are not. Besides these factors that we’re going to mention here on the Trading Academy, there is one more thing that makes the whole market shift: the U.S. dollar.
Why the U.S. Dollar is King
Since the Bretton Woods agreement, the U.S. dollar is being the world’s reserve currency. It is not known, or not clear, to be more exact if this is a burden or a privilege for the U.S. economy. This is because there are both advantages and disadvantages for your own currency to be the world’s reserve one. Nevertheless, because of that, everything is measured in dollars, even though recently there are some signs that things are being put in place to avoid dollar payments or to reduce the dollar’s influence.
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The World’s Reserve Currency
As a world’s reserve currency, the U.S. dollar is the currency that is used to clear all the deals around the world. Or at least most of them. Oil is denominated in dollars, and every purchase or payment one was to make via his/her own bank from other currency, is being made only after a dollar conversion takes place. This way there is one measured move for everything and flows into the dollar are both on the up and downstream. As mentioned earlier, it is not clear if this is a burden or a privilege for the economy that has its currency as the world’s reserve one. For instance, imagine the role of the central bank, in this case, the Federal Reserve of the United States (Fed). Because the whole world is moving around the dollar, as this is how the financial system currently works, the interest rate on the dollar is key for the global economy, not only for the United States. Therefore, the Fed has considered global factors as well as local ones when setting the interest rate for the dollar. Strictly from a mandate point of view, the Fed has a clear one: to keep inflation below or close to two percent and to create jobs. However, because the dollar is the world’s reserve currency, the Fed cannot simply move rates only based on the mandate, as the mandate refers to the local economy, the U.S. one. It is not surprising to hear the Fed talking about China’s economy, or about other factors around the world that made the Federal Open Market Committee (FOMC) postpone an interest rate decision. In reality, this is the norm.
Emerging Markets Connection
What happens with the U.S. dollar is crucial for emerging markets economies. As a quick note, emerging markets are the ones that base their growth on heavy loans and because of the U.S. dollar’s status, those loans are in dollars. To have an idea why this matters, consider the situation after the 2008 financial crisis: The Fed slashed the rates to almost zero and in the following seven years embarked on an easing program, the so-called quantitative easing. In turn, the dollar devalued against a basket of currencies, but something else happened: emerging markets could borrow in dollar terms at extremely cheap rates. However, the U.S. economy is at a point now that the risk of inflation is high and the economy is almost reaching full employment. This makes the Fed being pressured to hike rates. Those emerging economies that borrowed when the dollar was cheap would be forced to return the loans paying more for the dollar. Usually, emerging markets economies are extremely volatile due to various local factors and the fact that they must pay more because the interest rates in the United States are rising is only adding to uncertainty. Therefore, the Fed has an extremely difficult role when setting the interest rate on the dollar, as in fact, it is setting the interest rate for a currency that is used widely on a global scale. Nowadays what is happening with the U.S. dollar is even more important for the global economy. As we all know, Mr. Trump has become the new U.S. President and under this leadership, there are expected a lot of changes. Only the fact that he was elected propped-up the dollar. The idea behind a higher dollar comes from the fact that Trump promised to get rid of the 35% corporate tax that exists in the U.S. now for the profits that are being made outside the United States. If this is going to be changed, the U.S. companies might be interested to bring that hoard of cash back in the States and pay dividends to the shareholders, engage in local expansion, invest in research and development programs, etc. This, in turn, will lead to a shortage of dollars around the world. Because of everything discussed here emerging markets and the loans that exist, this shortage of dollars will pose an, even more, risk for the world’s economies. Moreover, populist measures and specially protectionist measures carry a high inflationary premium, and this is something that concerns Fed. In the end, the dollar is here to stay as the centerpiece for the world’s financial system, even though there are signs that in the future this may change. The recent acceptance of the Chinese Yuan in the IMF (International Monetary Fund)’s SDR (Special Drawings Rights) dilutes the role of the dollar, but nevertheless, it is here to stay for quite some time.
Recommended Further Readings
- Forex Trading – Explaining the Concept
– What is forex trading, generalities about trading the currency market.
- Why Trading Forex?
– Advantages and disadvantages of trading the currency market, what are trader’s expectations and what is a realistic approach to follow
- Opening a Live Trading Account
– How to open a live trading account – our helpful guide.
- Financial Products to Trade
– Different categories of financial products that a Forex Broker is offering for the retail clients, starting with the classical currency pairs, and continuing with commodities, CFD’s, indexes, etc.
- Forex Trading Sessions and Their Importance
– Explaining the differences between the three Forex trading sessions, what are their importance, ranking, etc.
- Forex Brokers Types – ECN or STP?
– What is ECN, STP, how d- brokers deal with client’s orders, advantages, and disadvantages of the tw- types.
- Forex Trading – Explaining the Concept
Other Educational Materials
- Political determinants of international currencies: What future for the US dollar?. Review of international political economy Helleiner, E. (2008). , 15(3), 354-378.
- “US dollar money market funds and non-US banks.” Baba, Naohiko, Robert N. McCauley, and Srichander Ramaswamy. (2009).