The strength and weakness of currencies are generally assumed to follow trends in supply and demand, and the United States dollar should be no different. Since at least the middle of the 20th century, however, the dollar has held a special status around the globe as a reserve currency. This means that individuals, companies and governments have carried out international trade and held their capital reserves in dollar-linked accounts.
The "Almighty Buck"
The dollar's position as a reserve currency can be traced to the period after the establishment of Federal Reserve Bank system in 1914 and the growth of U.S. trade around the world following WWI. Its position as a premier reserve currency was consolidated after WWII with expanded U.S. global trade.
Over time, that role was reinforced by the widespread perception that the U.S., backed by a stable institutional and political environment, is an economy that provides ample liquidity and a safe haven for investment from around the globe. This has given rise to an abundance of dollar trade outside the borders of U.S. territory known as the "eurodollar" market, which has amplified the global implications of U.S. policy moves and economic indicators.
As a reserve currency, the dollar historically has benefitted from particular stability in relation to many of its counterparts. However, even the dollar suffers from bouts of volatility. These are frequently in reaction to global geopolitical and economic events of "seismic" proportion, or events within the U.S. economy itself.
The dollar's status as a reserve currency is directly related to the U.S. government's commitment in the past several decades to a so-called "strong dollar policy," which aims to maintain the dollar at a relatively stronger level in relation to its counterparts. The policy has the effect of making imports less expensive for U.S. businesses and consumers, and exports more expensive for potential buyers abroad. It is also thought to encourage foreign investors to buy U.S. financial assets and reinforce the dollar's importance in global finance.
The dollar, like nearly all U.S. assets and many foreign assets, has shown special sensitivity to monetary policy from the U.S. Federal Reserve. The institution influences yields of U.S. treasury bonds, other securities traded in U.S. markets, and even securities traded abroad.
Additionally, monetary policy can affect the long-term prospects for activity and growth in the economy that influences revenues, earnings and dividends. As such, it is common for investors and the dollar rate to react, often in real time, to news and announcements related to interest rates and interest rate policy. These include events such as statements by Federal Reserve officials and the minutes of the Federal Open Market Committee (FOMC), where hints about future interest rate policy are thought to be revealed.
Monetary policy influence on the strength of the dollar was particularly evident over the past decade, when the Federal Reserve lowered interest rates to historic lows. This initially prompted a weakening of the dollar around the globe as investors moved their money to higher returns in assets abroad. The weakening trend was reversed later, however, when the Fed signaled it would once again raise rates, and investors from around the globe began to shift funds back to assets in the U.S. in pursuit of increasing yields.
Researchers have found that the dollar exchange rate reacts to data that can affect future monetary policy, as well as the prospects for U.S. economic activity itself. Studies by independent economists and by the Federal Reserve have shown that volatility of the dollar rate against other currencies increases around the release of a series of key economic indicators, such as GDP figures, consumer confidence, construction spending, inflation figures, durable goods orders, industrial production, manufacturing data, payrolls, new home sales, retail sales, the trade balance and unemployment figures.
Non-Data Events And Other Influences On The Dollar
In addition to undergoing influence from regular data releases, the dollar rate is occasionally influenced by world events and other factors that can affect the prospects for the U.S. economy. These may include news about global policy movements from world leaders and important international organisations, reports of conflicts between groups or governments in hotspots around the globe, or news of political or military power shifts in key economies.
The dollar rate can also be affected by significant corporate news, such as earnings, sales or employment reports from large companies that are deemed by investors to foretell the prospects for given sectors or for the economy as a whole.
Commodity And Oil Prices
Major moves in commodities and oil prices have also been found to have influence on the dollar rate.
Oil takes on particular significance among commodities for its effects on the U.S. economy and the dollar exchange rate. The U.S. economy is heavily dependent on oil. In 2014, oil use alone accounted for about 4% of the U.S. gross domestic product. The U.S. has been increasing its production of oil through development of shale oil reserves, but until recent years it had imported as much as 40% of its oil supplies for use as fuels in transportation and industry.
Data analysed by the Federal Reserve has shown that a 10 percent increase in the price of oil is associated with a drop of about 1.4% in the level of the U.S. real GDP. Further, increases in the cost of oil have been shown to promote increases in the costs of other commodities, making imports of needed materials for U.S. industry more expensive. The exact correlation between oil prices and dollar volatility, however, is not always clear.
Analysts point out that oil is generally priced in dollars around the globe. Thus, while supply and demand factors affecting the price of oil may have an impact on the dollar rate, the dollar rate itself may exert its own strong influence on the price of oil.
Tracking Volatility: Heat Waves Or Meteor Showers?
Regardless of its source, traders can further try to prepare for volatility by watching possible extreme movements of the dollar against other currencies. While random global events may be difficult to track, volatility often occurs surrounding the release of key economic data and at off-peak trading hours—early morning and early evening when investors try to position themselves amid periods of low volume for possible unexpected upcoming events or market movements.
Traders may also want to keep an eye on geographic and intermarket trends. Some studies have suggested that rather than following a "heat wave" pattern where volatility remains isolated in individual markets, it often follows a "meteor shower" pattern, spilling over from one market to the next in a movement of contagion.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…