The US dollar (USD) - Main features

US dollar

The US dollar (symbol: $, code: USD, also abbreviated US$ and denominated "dollar" or "US" "dollar") is the official currency of the United States and its island territories according to the United States Constitution. For practical reasons, it is divided into 100 smaller cent (¢) units, but it can be officially divided into 1000 units (₥). The currency is made up of Federal Reserve bank notes denominated in US dollars.

It is currently the most important currency in the world and the world's most traded reserve currency in the foreign exchange markets. Since the 1971 suspension of the convertibility of the US dollar into precious metal, the US dollar is, de facto, a fiduciary currency. As it is by far the most used currency in international transactions, the USD is the world's leading reserve currency. Several countries use it as an official currency and in many others it is the de facto currency.

As of 1 January 2019, there was approximately $ 1.69 trillion outstanding, including $1.65 billion in Federal Reserve notes (and $46 billion in the form of coins).

Below, we will describe the main features of the US dollar and its role in the global economy, starting with a description of the US economy relative to its currency.

Economic profile of the United States

Today, the United States is the world's largest economic power with a gross domestic product of over $19 trillion as of 2019. This value is calculated on the basis of the purchasing power parity model. It is 5 times that of Germany, 3 times that of Japan and 7 times that of the United Kingdom.

Today, the US economy is focused primarily on the services sector, with over 80% of its GDP being produced by retail, health care, finance, real estate and transportation services. However, the large size of the US manufacturing sector still makes the US dollar very sensitive to its performance.

Since the United States has the world's most liquid fixed income and equity markets, foreign investors are steadily increasing their purchases of US assets. In fact, foreign direct investment in the United States accounts for about 40% of the world's net inflows into the US. In net terms, the United States absorbs over 70% of total foreign savings, which means that if foreign investors are not satisfied with the profits made in the US asset markets, they may decide to repatriate their funds or invest them elsewhere, the value of these assets and the US dollar would therefore suffer considerably.

The volume of US exports and imports is greater than that of any other country. The size of its economy is such that it represents only 12% of GDP. Despite this, it is currently facing a large current account deficit, which continues to grow each year. This deficit has been the main problem of the US economy for over a decade (not counting the 2008 financial crisis, of course).

In recent years, the problem has worsened as economic financing has declined, as the central banks of other countries have diversified some of their reserve assets and shifted their denominations from dollars to euros. This large current account deficit makes the dollar very sensitive to changes in capital flows. Therefore, in order to avoid a further decline of the US dollar due to trade, the United States must attract a large volume of daily inflows of capital.

The United States accounts for around 20% of world trade and is also the largest trading partner of most countries. This is significant, because changes in the value of the dollar and its volatility have a significant influence on the United States' trade with other countries. Specifically, if the dollar is weaker (lower) than other currencies, it is more likely that US exports to trading partners will increase, but if the value of the dollar increases, demand for exports may decline.

Below you will find a list of the United States' major trading partners. The list of major export markets is relevant as it ranks these countries according to their growth and political stability. For example, if the Canadian economy slows, the demand for US goods and services will decrease, which will have a negative effect on the US economy.

  • Main export markets: Canada, Mexico, Japan, the United Kingdom and the European Union.
  • Main import sources: Canada, China, Mexico, Japan and the European Union.

Entity in charge of the US's monetary policy and budget: the Federal Reserve (FED)

The authority in charge of managing monetary policy in the United States is the Federal Reserve Board (FED). The FED's role is to define and implement the country's monetary policy through the Federal Open Market Committee (FOMC). In the FOMC, the voting members are the 7 Federal Reserve Board directors, as well as 5 presidents of the 12 district reserve banks. The FOMC holds 8 meetings a year, which are closely followed by the markets due to potential announcements relating to changes in interest rates and growth forecasts.

The FED now enjoys a great deal of independence in defining monetary policy because it is less subject to political influence because most of its members are in place for long periods of time. This gives them the opportunity to cover the various periods in which a party predominates in the presidency and/or in congress.

The Federal Reserve publishes a semi-annual report on monetary policy in both February and June. Then comes the Humphrey-Hawkins' speech, to which the Federal Reserve chairman fields questions from both the US Congress and the banking committees about the report. It is important to keep this report in mind as it includes the FOMC's unemployment, inflation and GDP projections.

Unlike most central banks, the FED has long-term sustainable economic growth and price stability goals. To achieve these goals, the Federal Reserve must use monetary policy as a means of achieving balanced growth and limiting both inflation and unemployment. The FED's most oftenly used tools to regulate the nation's monetary policy are open market operations "carried out at market conditions" and the federal funds target rate:

Open market operations

These transactions include the FED's purchase of government securities such as treasury bills. This is one of the FED's most used tools to indicate and implement policy changes. In general, if the FED increases purchases of these securities, interest rates fall, while the sale of these securities has the effect of increasing interest rates.

Federal funds target rate

The Federal Reserve's main tool is the federal funds target rate. This rate is defined as the interest rate used for loans that the FED offers to member banks. To reduce inflation, the Fed increases this rate, and to stimulate consumption and growth, it reduces it according to the country's current economic prospects.

Financial markets, including the forex, are closely tied to changes in this rate, as they typically involve significant policy changes and generally have significant implications for both the equity and fixed income markets. The markets also pay attention to all FED statements as they can provide hints regarding future monetary policy measures.

As far as tax policy is concerned, it is managed by the US Treasury. Decisions on fiscal policy include establishing the most appropriate public expenditure and taxation levels. In fact, although the financial markets pay more attention to the FED, the government entity that actually determines dollar policy is the US Treasury. For example, if the Treasury considers that the exchange rate of the dollar on the foreign exchange markets is overvalued or undervalued, it is the government entity that gives the Federal Reserve the power and order to intervene directly on the market, either by buying or selling dollars. Therefore, as far as the forex is concerned, the Treasury's view on the dollar's policy and its variations is generally of utmost importance.

In recent decades, the FED and the Treasury have both had a policy that favours a stronger dollar. Under the Bush administration, this view was supported and a preference for a strong dollar was emphasised. However, during the 2003-2005 period, little was done to halt the decline of the dollar, which led the market to believe that the US government was in fact favoring a weak dollar as a means to stimulate economic growth. For political reasons, the US government is unlikely to openly indicate a change in its preferences and policies.

Main features of the US dollar

Currently, over 90% of forex trades are made with a pair of currencies that includes the US dollar: the most liquid currencies on the forex are the EUR/USD, USD/JPY, GBP/USD and USD/CHF pairs, which are also the most traded in the world. The US dollar is included in all of these pairs, which explains the great importance that the US dollar has for forex traders. For this reason, the most significant economic information that usually produces the strongest movements in the market is fundamental data relating to the dollar (US economy).

The US dollar is generally negatively correlated with gold: historically, the US dollar price and gold prices have had almost perfectly negative correlations. This means that when the price of gold goes up, the value of the dollar goes down and vice versa, which is mainly due to the fact that gold is measured or valued in dollars. In recent years, the depreciation of the dollar due to global economic uncertainty has been the main cause of the increase in the value of gold, gold being generally considered a safe haven in times of crisis. Gold has been considered the safest commodity and, therefore, in times of crisis, investors tend to use gold as a safe haven, which essentially has a negative effect on the dollar.

Several emerging markets have established an exchange rate parity between their currency and the US dollar: this measure was adopted with the idea that the governments of these countries accept that the dollar becomes their reserve currency by offering to buy or sell any amount of their local currency at the established exchange rate. In general, these countries must also commit themselves to having a reserve of that currency which is at least equivalent to the amount of the local currency in circulation. This is extremely important as central banks in these countries accumulate large sums of US dollars and actively participate in the management of their fixed or floating parities. In some cases, these countries participate actively in the foreign exchange market.

Markets tend to pay close attention to interest rate spreads between US Treasuries and foreign bonds: this relationship is very important and should be closely monitored by all forex traders as it is a good indicator of potential fluctuations in currency prices. The US market is one of the largest in the world and investors are very sensitive to changes in US asset returns. Major investors are always on the lookout for the most profitable investments, and if the returns they get in the US go down or rise abroad, they might be tempted to sell their US assets to invest in foreign assets. The sale of US fixed income assets requires the sale of US dollars and the purchase of foreign currencies, which has an impact on the forex and causes a decline in the value of the dollar. Conversely, if the return on US assets rises or falls, investors are more willing to invest in US assets, which increases the value of the dollar, because you have to buy more dollars to buy those assets.

The Dollar Index: Professional forex traders closely follow the behaviour of the Dollar Index (USDX) as an indicator of the overall strength or weakness of this currency. The USDX is a futures contract traded on the New York Board of Trade. It is calculated using the geometric mean of 6 currencies and is weighted according to foreign trade. It is important for traders to pay attention to this index, because when analysts and market participants report a general weakness of the dollar or a weighted drop in terms of foreign trade, they usually refer to this indicator. However, if the dollar moves significantly against a specific currency, this movement may not have been as important if it is weighted according to foreign trade. This is important because some central banks may choose to focus on this index rather than the behaviour of the specific currency pair in relation to the US dollar.

Before the 11 September 2001 terrorist attacks, the US dollar was considered one of the safest currencies: the reason for this is that before this event, the risk of high volatility in the United States was very low. This country was recognised as one of the most developed and safest markets in the world, and the dollar had a security status that allowed the United States to attract investments even at lower rates of return. This means that 76% of global monetary reserves were denominated in US dollars. Another reason for this is that the dollar is the dominant currency in global factoring. In choosing a reserve currency, the security offered by the dollar has been an important aspect taken into account by foreign banks in other countries. However, since 11 September, US asset holders, including central banks, have reduced their assets due to increased uncertainty in the United States and lower interest rates. The rise in the euro also threatened the dollar's position as the world's first reserve currency. Some central banks have even begun to diversify their reserves, which has resulted in a reduction in their dollar assets and an increase in their euro-denominated assets. However, with the economic crisis that Europe has experienced in recent years and the questioning of the very viability of the euro as this economic zone's single currency, this trend could change. Traders who invest in currencies over the long-term will need to carefully analyse these conditions over the next few years.

Foreign exchange transactions in the United States are influenced by the stock and bond markets: there is a strong correlation between a country's currency and its equity and fixed-income markets, which is clearly the case in the United States.

Factors influencing the value of the US dollar

Since the US dollar is the United States' currency, when economic activity in the country is strong, the dollar usually strengthens; and conversely, when economic activity slows down, it weakens.

Moreover, since the United States is also considered a haven of peace, the dollar tends to appreciate during periods of global financial or political turbulence. US politicians have always been in favour of a strong dollar and the US Treasury sometimes intervenes on the foreign exchange markets when it thinks that the dollar is too weak.

Today, the US dollar plays a unique role in the world of international finance. As the world's reserve currency, the dollar is used for most international transactions. When central banks hold foreign currency reserves, a large percentage of these reserves are typically held in US dollars. Similarly, many countries with a small economy choose to tie the value of their currency to the US dollar or give up their own currency, preferring to use the US dollar instead.

More specifically, the factors that affect the value of the US dollar are:

The opposition between the supply and demand of dollars

When US producers export products or services, they create a demand for dollars because their customers have to pay for their goods and services in dollars. Therefore, they have to convert their local currency into dollars, so they have to sell their currency to buy dollars in order to make the payment. In addition, when the US government or large US companies issue bonds to raise capital, and if these bonds are purchased by foreigners, the bonds must be paid for in dollars and the customer must sell his local currency in order to buy dollars to make the payment. If there is strong growth in the country and companies increase their profits, the desire of foreigners to own shares of these US companies also requires them to sell their currency to buy dollars to buy the relevant stock(s).

These situations create greater demand for dollars and, as a result, put pressure on the supply of dollars, which increases the value of the dollar against the currencies that are sold to buy dollars.

Market sentiment and psychology

But what if the US economy weakens and consumption slows down due to rising unemployment? In this scenario, the United States faces the possibility that foreigners will sell their US bonds or stocks and change the money from the sale of these assets back into their local currency. As a result, they will sell their dollars and buy back their local currency. This type of activity has a negative effect on the dollar.

News and economic indicators that affect the value of the US dollar

Investors and traders must assess whether the supply of dollars is above or below the demand for them. To determine this, it is important to pay attention to key economic news and indicators.

In theory, the indicators and economic events that most affect the US dollar are those related to the evolution of the US economy. Various indicators such as labour sector reports (such as non-agricultural wages), inflation indicators, gross domestic product, etc., can have a more or less significant impact on the value of the dollar, mainly due to the nation's economic context at the time of publication, the values ​​of the indicators and to what extent they are in line with investors and analysts' forecasts (expected results). On occasion, and depending on the combination of these factors, these indicators can lead to significant changes in monetary trends.

As with all currencies, major changes in the monetary policies of a country's central bank, in this case the FED, can have a significant impact on the dollar, particularly in relation to other currencies. The impact is even greater when the changes involve changes in interest rates. A rise in US interest rates can almost certainly lead to an increase in the value of the US dollar versus other currencies, with medium and even long-term upwards trends, while a fall in the country's interest rates can have the opposite effect. Even the slightest signal from the FED of a possible rise or fall in interest rates can shake the markets. The importance of the dollar is such that sometimes announcements that no changes will be made also provoke reactions in the market, especially when measures were expected.

Markets therefore closely monitor all FOMC meetings where changes in US interest rates can be announced as investors are aware that these announcements can provoke strong reactions and changes in the markets in which they regularly trade. Even the minutes of the FOMC meetings, which are published a few weeks after each meeting, are followed by investors looking for signals about future changes in monetary policy and FOMC members' views on the US economy. The opinions of these officials also offer clues that are taken into account by investors.

More information on the economic indicators that can affect the US dollar is available in the following article:

- Main economic indicators of the US economy and the US dollar

Market sentiment and the technical analysis elements that can influence the dollar

Investors must also determine the general sentiment about what market participants view as the likely outcome of various events and economic indicators, as well as the future course of the global and US economies, as well as the US dollar's behaviou itself. Market movements that do not seem to be explained by fundamental analysis are often produced by the sentiment of market participants, although this doesn't always seem to make much sense, from a logic standpoint. Very often, it is sentiment that will determine the market's direction rather than fundamentals factors that are based on supply or demand. To add to this combination of factors, we must also take into account historical trends generated by seasonal factors, significant support and resistance levels, technical indicators, and so on. Many traders believe that these models are repetitive and can therefore be used to predict future movements.

The dollar on the currency exchange market

As noted above, over 90% of forex trades involve the US dollar, making it the most traded and liquid currency. Virtually all currencies are traded with the dollar, from those of the most advanced economies to developing countries' exotic currencies. This is why it is considered the world's reserve currency.

Most currencies are traded against the US dollar in currency pairs, more often than those of other currencies. For this reason, it is essential that investors interested in foreign exchange markets have a clear understanding of the fundamentals of the US economy and a solid understanding of the general medium and long-term dollar trends.

Currently, the main currency pairs that are traded are the dollar-based ones linked to the world's principle economies. These currency pairs are:

  • EUR/USD
  • USD/JPY
  • GBP/USD
  • AUD/USD
  • USD/CAD
  • USD/CHF
  • NZD/USD

These pairs cover most currency transactions that involve the US dollar, but there is also a large volume of transactions that feature lesser known or even "exotic" currencies against the US dollar.

The dollar on the financial markets

Not only is the US dollar the most traded currency on the foreign exchange markets, but it is also the most widely used currency for transactions in the world's various financial markets. A wide variety of assets and financial instruments are quoted in US dollars, that is, in the currency that is used to determine their value. Thousands of stocks, derivative financial instruments (futures, options, forwards, CFDs, etc.), indices, bonds, etc. are traded in US dollars. Although many of these instruments are also traded in other currencies, such as the euro, the dollar still dominates by far.

For example, futures, which are one of the world's largest markets, are traded primarily in dollars, whether commodity or currency futures.

Even cryptocurrencies such as the Bitcoin are traded mainly in dollars.

The prices of gold and many other commodities (agriculture, energy and other commodities) are usually quoted in US dollars. In addition, OPEC (Organization of the Petroleum Exporting Countries) conducts its transactions in USD. This means that when a country buys or sells oil, it also buys and sells US dollars at the same time. All of these factors contribute to making the dollar the world's most important currency.

It is therefore not surprising that the dollar is currently the most traded currency.

Previous: How do fundamentals affect prices on the forex?
 Next: The British pound (GBP) - Main features