Forex trading: Understanding the United States dollar

This article describes the characteristics of the USD, the world's most popular currency. It also describes the relationship between the USD and financial products such as bond yields and gold.

With the world's most significant trading volume, the USD is often also bought as a safe-haven asset.

As the currency of the United States, the world's largest economic and military power, the US dollar enjoys a unique "world currency" status and global acceptance across financial markets. In addition to being the most widely used currency for international trade and financial transactions worldwide, the Dollar also serves as the primary reserve currency for the central banks of numerous nations making it central to the global economy.

According to data released by the Bank for International Settlements (BIS), over 40% of forex trade in 2022 was in USD¹. Since the USD is traded worldwide and has high liquidity, it is considered a safe-haven currency with both JPY and CHF.

The US dollar is frequently regarded as a "safe haven" currency during times of market instability or geopolitical risk, and there is a strong tendency for investors to buy USD during these periods in order to diversify and de-risk their portfolios. However, since the terrorist attacks of September 11, 2001, there has been a growing trend towards selling the Dollar².

Since the USD is the currency of the United States, the policies of the Federal Reserve, the US central bank, and core US economic indicators all significantly impact the value of the US dollar.

The monetary policy of the United States is determined at eight meetings held annually by the Federal Open Market Committee (FOMC).

The market closely follows these meetings, with the focus being on the decisions, policy statements, chairman's press conferences, and FOMC minutes, causing the US dollar to sometimes overreact based on the direction of the monetary policy.

Historically, when the FOMC would tighten monetary policy, the market tends to buy the US dollar, and when it would loosen its policy, the market would tend to sell the US dollar.

When the US economy is booming, the Federal Reserve tends to tighten monetary policy to prevent the economy from overheating and prices from rising.

Specifically, it raises interest rates in order to maintain economic stability.

Financial policies are also implemented to stimulate the economy when this slows down and the inflation rate falls.

When interest rates are cut and bonds become attractive, money flows into the market, stimulating the economy and driving price increases.

Generally speaking, financial policies that tighten the economy will increase the currency's value, making it a factor in buying USD. Monetary policies that loosen the economy will reduce the currency's value, making it a factor in selling USD.

However, suppose prices remain relatively high compared to other countries in the medium to long term. In that case, the currency's value will fall according to the Law of One Price, which states that the price of the same asset will have the same price globally when certain factors are taken into consideration so it can also be a factor for selling.

Bond yields are a great indicator of the strength of a country's stock market, which increases demand for the country's currency. The relationship is fairly linear: any increases in US bond yields were likely to increase demand and therefore price of the US dollar. As higher yields are often favoured by more risk-inclined investors, higher bond yields can also be a signal of the market's risk tolerance expanding. This isn’t always the case but it is accurate most of the time.

Below is a chart comparing the US Dollar Index to US 10-year and 2-year bond yields. As can be seen, the correlation is not always present.

For example, the chart below compares the USDEUR yield (1÷EUR/USD) and the US 10-year bond yield minus the German 10-year bond yield. The two data points are often moving in the same direction, so it may be easier to understand the direction of the general trend by comparing them in this way.

In the case of USD/JPY, the difference in yield between US bonds and Japanese bonds tends to be correlated, while in the case of GBP/USD, the difference in yield between US bonds and UK bonds tends to be related.

There is often a negative correlation between the US dollar and gold.

That is, historically, when the dollar would rise, the price of gold fell, and when the dollar fell, the price of gold rose.

We find the same relationship when the value of money decreased, and the price of goods rose, and when the value of money increased and the price of goods fell.

Because crude oil is priced in US dollars, this inverse relationship is also present in the oil market, meaning that when the value of the US dollar falls, crude oil prices tend to rise, and vice versa. However, there are other fluctuations in the oil market due to a range of factors, such as supply and demand or geopolitical events. Gold is the most prone to exhibit a negative correlation with the US dollar.

The chart below compares EUR/USD, Dollar Index expressed by USD strength and gold price. As can be seen, the correlation is strong.

If you divide 1 by the USD index, the above chart will be displayed upside down.

Footnotes:

1 - https://www.bis.org/publ/qtrpdf/r_qt2212f.htm

2 - https://www.everycrsreport.com/reports/RS21934.html