What is the US Dollar?
The US Dollar (USD) is the official currency of the United States. It was established after Congress passed the Mint Act on April 2, 1792. During the Civil War, the government issued paper money in the form of “demand notes”, that later became known as “greenbacks” due to their color. Traders and analysts now often use “greenback” as an unofficial term for the U.S. Dollar.
The Creation of the Federal Reserve
In 1791, the U.S. chartered the First Bank of the United States the forerunner to the modern U.S. central banking system. However, when the time came for its renewal in 1811, the legislation did not pass due to overwhelming opposition in Congress. In 1816, the Second Bank of the United States was chartered and scheduled for renewal in 1836, only to be denied by President Andrew Jackson.
From 1837-1863, the so-called “free banking era” was characterized by numerous bank failures and elevated economic volatility. A myriad of state banks overextended credit due to the lax regulation around reserve requirements that resulted in waves of bank blowups and economic depressions. Each bank issued its own currency, which caused a great deal of confusion about what was a legitimate or counterfeit U.S. Dollar.
To quell the chaos, Congress passed the National Banking Act of 1863 and 1864, establishing the United States National Banking System and supporting a uniform banking policy. Less than fifty years later, the Federal Reserve System was established in 1913 as an institutional mechanism to mitigate economic volatility.
The Global Greenback
In 1944, the Bretton Woods System was established, effectively forming the modern day international financial system with the U.S. Dollar at the center. Along with the creation of the IMF and World Bank, the agreement pegged thirteen of the world’s most traded currencies at the time to the U.S. Dollar, which was in turn tied to gold.
However, this system was put under stress by the Vietnam War and Great Society social welfare program in the late 1960s and early 1970s, with more dollars entering into circulation than could be redeemed in gold. Facing inflationary pressure, President Richard Nixon temporarily suspended the international convertibility of U.S. Dollars into gold in 1971. By 1973, the Bretton Woods System had officially collapsed. The U.S. Dollar has been a “fiat currency” ever since, meaning it is backed only by faith in the Federal Reserve and the United States government.
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What moves the US Dollar?
I. Federal Reserve monetary policy
The Fed plays a crucial role in influencing the U.S. Dollar price trend. Its “dual” mandate is to maximize employment in a context of price stability, which is expected to produce moderate to long-term interest rates. In 2012, under Chairman Ben Bernanke, the Fed defined USD price stability by setting an inflation target of 2%.
The central bank uses open market operations and other monetary policy levers to provide liquidity as needed. If economic growth is strong, inflationary pressure rises, and the Fed is likely to attempt to cool activity by raising interest rates. Conversely, if there is a downturn, disinflationary pressure is likely to push the Fed to lower rates as a way to spur a pickup in economic growth.
For example, the bursting of the “dot-com” asset price bubble in 2000 triggered a recession and the Fed embarked on an interest rate cut cycle. Consequently, the U.S. Dollar fell. Conversely, the unwinding of exceptional levels of monetary stimulus following the global financial crisis of 2008 led USD sharply higher, with prices advancing to a 15-year high by early 2017.
The effect of the Dot-com Crash on USD
The effect of unwinding Fed Quantitative Easing (QE) on USD
The U.S. central bank also holds press conferences where markets can approximate the direction of interest rate hikes or cuts based on hawkish or dovish rhetoric from Fed officials. Additionally, indicators of economic activity such as GDP and CPI reports, along with PMI surveys, have a noteworthy effect on the dollar by way of shaping Fed policy expectations.
Unexpectedly positive or negative data from these various indices has a tendency to lead markets to speculate on potential hawkish or dovish shifts in the policy path. The readjustment of portfolios to account for such changes translates into US Dollar exchange rate fluctuations.
II. Market Sentiment
Swings in broad-based market sentiment trends are another important driver of US Dollar price action. Over 80 percent of all global monetary transactions are settled in the greenback, according to data from the Bank of International Settlements. That makes it by far the most liquid of the major currencies.
What this means in practice is that it can absorb large in- and outflows of capital with relatively less volatility than alternatives. That often makes it a natural choice for traders looking to “cash out” of their investments at times of market stress when focus shifts from prioritizing returns to capital preservation.
This has frequently produced an inverse relationship between the US Dollar and assets anchored to a positive market sentiment – such as stocks, commodities and high-yielding currencies – at times of market stress. Indeed, the Dollar scored explosive gains amid the global financial crisis in the second half of the 2008 despite the US being the epicenter of the turmoil.
The effect of risk-off sentiment on the US Dollar during the Great Recession
Trading the US Dollar
The US Dollar is the most traded currency in the world, commanding 87% of all market turnover (according to the Bank of International Settlements). Put simply, this means that nearly 90% of all global monetary transactions involve the greenback. This makes it the USD the world’s premier reserve currency.
This means three things:
1 - A change in U.S. interest rates has knock-on effects on the cost of borrowing globally. That makes Fed monetary policy one of the defining forces directing the worldwide business cycle. Trading the U.S. Dollar is thereby a natural way to express a view on the fate of the global economy as a whole.
2 - Unparalleled liquidity often makes USD the cash of choice when traders divest from their investments at times of market turmoil. In practice, this means the currency tends to rise in periods of acute stress, making it a vehicle for taking bets on broad sentiment trends.
3 - Lower transition costs can be another benefit of the greenback’s deep liquidity. USD-linked currency pairs frequently offer lower bid/ask spreads than alternatives. For example, the cost of a bet on the direction of the Euro may be lower if it is made via EUR/USD rather than EUR/JPY or EUR/AUD.
Commonly traded USD currency pairs:
--- Written by Dimitri Zabelin, Jr Currency Analyst for DailyFX.com
To contact Dimitri, use the comments section below or @ZabelinDimitri on Twitter
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