US Dollar Currency Profile

Know the US Dollar intimately as a currency trader. It is important for you as currency trader to have a good grasp of the general economic characteristics of the most commonly traded currencies. US Dollar is the most heavily traded currency in the global economy.

You should know as a trader what moves the currencies particularly the pairs that you are interested in trading. Traders need to also know the difference between the expected and the actual data. Some currencies tend to track commodity prices while others may move in complete contrast.

Expectations are what move the markets in the short term. Short term traders need to closely monitor the expectation of the currency markets. News or data that is in line with the expectations has less of an impact on currency movements than unexpected news or data. The correlation between the currency markets and news is very important.

US GDP is approximately five times the size of Germany, three times the size of Japan and seven times the size of UK. United States is the world’s leading economy. The US economy is now a service oriented economy with almost 80% of GDP coming from real estate, finance, health care, transportation and business services.

United States capital markets are the most efficient markets in the world. United States has the world’s most liquid and deep equity and fixed income markets in the world. The manufacturing sector is still formidable and US Dollar is particularly sensitive to the development within the sector. Cheap capital formation is what drives any company or any economy and United States capital markets help in cheap capital formation.

The import and export volume of US also dwarfs the countries. This maybe due to the sheer size of US as true import and export represent only 12% of the GDP. Foreign Direct Investments (FDI) into the US is equal to almost 40% of the total net inflows for United States. Investors from all over the world purchase US assets due to their liquidity and safety.

Current Account Deficit & US Dollar
However, United States is running a large CA deficit for more than a decade now. US economy is facing the paradox of the twin deficits. One is the Budget Deficit and the other is the Current Account (CA) deficit. During the present financial crisis, the budget deficit has ballooned. Almost a trillion dollars have been added to the budget deficit. This is going to fuel inflation when the economy recovers. There are dangers of high inflation returning. Inflation can make the US Dollar weak in the long run.

Due to the high CA deficit; United States need to attract a few billion dollars of capital inflows daily in order to prevent the decline in the value of US Dollar. In other words, the Current Account (CA) deficit is being financed by the Capital Account (KA) surplus. The large CA deficit makes the US Dollar highly sensitive to changes in the capital flows.

United States is a member of the World Trade Organization (WTO). This means that United States is heavily committed to the free trade idea. A weaker US Dollar will help boost US exports whereas a stronger US Dollar makes the US exports expensive and US imports cheap. US trade is equal to roughly 20% of the world trade. United States is the trading partner of many countries across the globe.

Leading import sources for United States are: China, Mexico, Japan, Canada and European Union (EU). Leading export markets for United States are: Japan, European Union (EU), United Kingdom, Canada and Mexico. The growth and political stability in countries that are leading export markets for US are important. For example, Canada’s demand for US exports will fall that will have a ripple effect on US growth should Canada growth slow.

FED & US Dollar
You should understand the role of monetary and fiscal policy in strengthening or weakening the US Dollar or that matter any other currency is important. Who makes the monetary policy in any country? It is the Central Bank of that country. The Federal Reserve Board (FED) is responsible for making the monetary policy of United States. Through its Federal Open Market Committee (FOMC), FED sets and implements the monetary policy. The voting members of FOMC are the seven governors of FED plus five presidents of the district reserve banks. The meetings of FOMC are widely watched by the analyst for interest rate announcements and changes in growth expectations. Eight meeting of FOMC are held every year.

FED uses the monetary policy to control inflation, unemployment and balanced growth. FED has a high degree of independence in setting the monetary policy. FED has the mandate for long run price stability and sustainable economic growth. In other words, fighting inflation and unemployment are the two most important jobs of FED Chairman. The most important tool used by FED is its Open Market Operations.

Monetary policy uses control of interest rate to increase or decrease the money supply in the economy to achieve its growth objective. FED controls the short term interest rate through its open market operations. It involves FED’s sale or purchase of government securities that includes treasury bills, notes and bonds. Increase in FED’s purchases lowers the interest rates while selling of these securities raises the interest rate.

Federal Fund Rate is the key policy target of the FED. It is the interest rate at which the banks lend overnight to one another in the overnight interbank market. The primary interest rate that is affected by these operations is the Federal Fund Rate. The market then adjusts the other short term and long term interest rates accordingly. FED does not directly sets the Federal Fund Rate. It establishes a target rate through the open market operations.

US Treasury & US Dollar
The other main pillar of economic policy is the fiscal policy. Who controls the fiscal policy? The governments in almost all the countries! Fiscal policy means the amount of taxes and government spending for a given year. The US fiscal policy is in the control of US Treasury. In fact it is the US Treasury that actually determines the US Dollar policy.

You should always try to watch the US Treasury views as changes to that view is very important for the currency markets. For example, US Treasury can give instructions to the New York Federal Reserve Board to intervene in the forex markets by actually buying or selling US Dollars if the US Treasury feels that the US Dollar is under or overvalued.

EUR/USD, USD/JPY, GBP/USD and USD/CHF are the most heavily traded currency pairs in the global currency markets. These currency pairs represent the most frequently traded currency pairs in the global markets. Over 90% of all currency deals involve the US Dollar. As you can see, all these currency pairs involve US Dollar on either side of the pair. So the most important economic data for the global currency markets is the US Dollar fundamentals.

Gold & US Dollar
The relationship between Gold and US Dollar is very important for you to understand. There is an almost perfect negative correlation between the US Dollar and the gold prices. The US Dollar moves in opposite direction to the gold. This inverse relationship stems from the fact that gold is measured in US Dollars.

When US Dollar depreciates due to global economic uncertainty like the present, gold appreciates. Similarly when the US Dollar will appreciate on the news of US economic recovery, gold prices will go down. Gold is commonly viewed as the ultimate safe haven commodity by the investors all over the globe. You must know that the gold prices are going up right now and have reached very high levels. Gold trading and currency trading can be a very powerful combination.

United States was known to have one of the safest and the most developed capital markets in the world. As the risk of severe United States instability was considered to be very low, US Dollar was considered one of the premier safe haven currencies in the world prior to September 11.

US Dollar reserves were very popular among the foreign countries and foreign investors. US Dollar was considered to be very safe. Almost 76% of the global currency reserves were in US Dollar. This allowed United States to attract investments from all over the world at a discounted rate of return. However, due to the present United States financial crisis, foreign investors and the Central Banks are not so sure about the US Dollar due to the increased US uncertainty. The decreasing interest rates and continuing recession is forcing foreign investors to think of other alternatives.

China & US Dollar
China pegs its currency to US Dollar. China has been accused by the United States many times of using this practice to keep its national currency artificially weak in order to boost its exports. There are many other developing and emerging countries that peg their local currencies to US Dollar. China is a very active participant of the global currency markets because its maximum float per day is controlled within a narrow band based on the previous day’s closing US Dollar rates. Any fluctuations beyond this band will invite intervention by the Chinese Central Bank that may include buying and selling US Dollars. Important countries that peg their currencies to US Dollar are China and Hong Kong.

EU represents a market as large as US with its own single currency Euro. The emergence of Euro is also threatening the US Dollar as the world’s premier reserve currency. Euro has provided an alternative to the US Dollar. With the passage of time, it is feared that Euro will emerge as a strong challenger to the dominance of US Dollar. Recently a group of countries like China, France and others have called for the introduction of a new global reserve currency by the IMF that should replace the US Dollar. If this happens in the next few years, it may have far reaching implications of the US Dollar and the US economy.

Many analysts fear a major devaluation of US Dollars in the near future due to the present financial crisis in the United States. Many central banks have already begun to diversify their foreign exchange reserves by reducing their US Dollar holdings and increasing their holdings in Euro and the gold. The US markets are the largest markets in the world and the investors all over the world are very sensitive to the yields offered by the US assets. Money flows where the returns are high. Interest rate differentials can be a very strong indicator of potential currency movements. The interest rate differentials between the US Treasuries and foreign bonds are followed by the professional forex traders with keen interest.

US Dollar Index
It is important that you follow the US Dollar index because when the market analysts are talking of general US Dollar weakness, they are referring to this index. The USDX is a futures contract traded on the New York Board of Trade (NYBOT). Market participants closely watch the US Dollar Index as an indicator of overall US Dollar strength or weakness.

The US Stock and Bond markets also impact US Dollar. Cross border merger and acquisitions involve big forex transactions and are also very important for forex traders to watch. The following economic indicators are important for the US Dollar: Employment, Nonfarm payrolls, Consumer Confidence, Retail Sales, Consumer Price Index, Produced Price Index, GDP, International Trade, Employment Cost Index, Industrial Production, TIC Data etc.