Profile of United States dollar – important facts
This lesson will cover the following
- Dominating currency in all transactions worldwide
- Other currencies, pegged to the US dollar
- Interest rate differentials between US government bonds and foreign bonds
Important facts regarding the United States dollar
First of all, over 90% of all currency transactions worldwide include the US dollar. Currency pairs such as EUR/USD, GBP/USD, USD/JPY and USD/CHF are the most liquid ones in the foreign exchange market and respectively, traders prefer trading them the most. All these include the US dollar, which implies how important it is to market players. This explains why economic, political and other events, occurring in the United States, trigger significant movement in most segments of financial markets.
Second, before the events on September 11th 2001 the US dollar was regarded as one of the premier safe haven currencies in the world. The reason for it was that the risk of major instability in the United States occurring was very low. The country was regarded as having one of the most secure and most developed markets worldwide. Because of the safe haven status of the dollar, investments at a discounted rate of return were pouring in the economy, as 76% of global currency reserves were held in US dollars. The dollar plays an important role as being the dominant factoring currency worldwide.
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Following 9/11, foreign investors, including central banks, reduced their holdings of US dollars, because interest rates fell and uncertainty in the country increased. What is more, the appearance of the euro was taken as a sign that US dollars status as a premier reserve currency might be at risk. A number of central banks have already started diversifying their reserves by increasing their possessions of euros and reducing their dollar-denominated holdings.
Third, a number of developing economies peg their domestic currencies to the US dollar. This means that their governments reached agreements to maintain the dollar as a reserve currency and meanwhile buying or selling amounts of their domestic currencies at the pegged rate for the reserve currency. At the same time, governments are obligated to hold reserve currency at least equal in amount to that of the domestic currency in circulation. Countries with their currencies pegged to the US dollar are Hong Kong and until July 2005 – China. Until July 21st 2005 China had pegged the local currency at a rate of 8.3 yuan per US dollar. After having been urged to revalue its currency for years, China set the USD/CNY exchange rate to 8.11 and adjusted the rate to the closing price each day.
Fourth, interest rate differentials between US and foreign government bonds are closely watched by market players. This relationship may indicate potential movement in the foreign exchange market, as US financial markets are among the largest in the world and investors tend to react quickly to changes in yields, which US assets offer. As we said, huge corporate investors are interested in higher-yielding assets. In case asset yields in the United States lower or asset yields elsewhere in the world increase, investors will be urged to sell their US assets and buy foreign ones. A possible sell-off of US stocks and fixed income assets will cause an impact on the foreign exchange market, because this will lead to a sell-off of the US dollar and relocation of funds to foreign currencies. In case US asset yields rise or foreign asset yields decrease, this will lure investors to US markets and, respectively, will increase demand for the US dollar.
Fifth, stock and bond markets influence US dollar trading. In case stock markets are in an uptrend, foreign investment dollars would be pouring into the economy. In case stock markets are plunging, local investors would likely cut their possessions of local publicly traded companies and search for suitable opportunities elsewhere. As far as the fixed income market is concerned, countries, offering the highest yields, will likely lure investors from abroad. Daily movements in both of these markets reflect movement of foreign portfolio investments, as the latter is related to transactions in the foreign exchange market.
In addition, significant mergers and acquisitions and especially those, including considerable cash portion, will greatly influence currency markets, because the acquiring company will buy or sell US dollars in order to finance its cross-border deal.