Foreign exchange, or forex, trading is an increasingly popular option for speculators. Ads boast of "commission-free" trading, 24-hour market access and huge potential gains, and it is easy to set up simulated trading accounts to allow people to practice their trading techniques. (For more, see Forex Trading: A Beginner's Guide.)
TUTORIAL: Forex Currencies: Introduction
With that easy access comes risk. It is true that forex trading is a huge market, but it's also true that every single wannabe forex trader is going up against thousands of professionals working for major banks and funds. The foreign exchange market is a 24-hour market and there is no centralized exchange – trades take place between individual banks, brokers, fund managers and other market participants – but 10 firms dominate nearly 75% of the volume.
It is not a market for the unprepared, and investors would do well to do their homework beforehand. In particular, would-be traders need to understand the economic underpinnings of the major currencies in the market and the special or unique drivers that influence their value. (For more, see The Greatest Currency Trades Ever Made.)
Introduction to the United States Dollar
The United States dollar is by far the most significant currency in the global market; it is the dominant reserve currency of the world, it represents nearly half of the trading volume of the major currencies, and it is the default currency for most transactions. Given that the U.S. economy is far and away the largest single economy in the world (close to three times the size of second place China), it is not surprising that the U.S. dollar holds the position that it does. (For more, see Top 6 Factors That Drive Investment In China.)
The U.S. dollar has not always held this position. Prior to World War II, the British pound enjoyed much of the same influence and prestige that the dollar currently holds. As the U.S. dominated the post-war economic landscape, though, the significance of the dollar increased accordingly.
The central bank of the United States is the Federal Reserve. Like most central banks, the Federal Reserve balances a mandate to both encourage economic growth and control inflation. The huge scale of the U.S. federal bond market complicates the Fed's mandate to some extent; Treasury bonds are popular around the world and seen as a proxy for risk-free investment. Interest rates in the United States were quite low during the credit crisis as the Federal Reserve tried to stimulate the economy, but worries about persistently high budget deficits and a growing national debt suggest a real risk of higher rates in the future. Because of the size of the U.S. economy and its bond market, the actions of the Federal Reserve can have a disproportionate effect on interest rates around the world. (Find out how the Fed manages bank reserves and this contributes to a stable economy. For more, see How The Federal Reserve Manages Money Supply.)
The Economy Behind the U.S. Dollar
Although the U.S. economy is the largest in the world, most of the focus on it in the post-housing bubble world is on the growing problems that threaten that top position. With the exception of the last three years of the Clinton presidency (and the first year of the Bush presidency), the United States has run persistent budget deficits since 1950 and faces a growing national debt. What's more, future obligations to Social Security, Medicare, Medicaid and debt repayment create a significant potential problem for the economy. (For related reading, see Breaking Down The U.S. Budget Deficit.)
The United States is increasingly a service-based economy. While the U.S. has the largest economy in the world, it is in third place in the value of its exports, behind China and Germany. Much has been made of the "hollowing out" of the U.S. manufacturing base, as companies have increasingly located manufacturing outside of the U.S. to take advantage of lower wages and costs. The U.S. is still a leader in technology, financial services and media, though, and the U.S. economy is increasingly dependent on these industries as a source of competitive advantage.
Drivers of the U.S. Dollar
There are numerous models and theories that attempt to predict currency exchange rates on the basis of relative interest rates, price levels, and so on. These models do not work especially well in practice, though, as traders consider numerous factors in their buy/sell decisions and the momentum of speculation itself can influence exchange rates. In other words, currency is like another "product" with extensive supply and price is determined by changes in demand. (For related reading, see 3 Factors That Drive The U.S. Dollar.)
While demand for U.S. dollars is certainly influenced by its key role in global trade (trade counterparties need to buy or sell dollars to conduct business), the value of the dollar is also heavily influenced by economic data. Data that makes the U.S. economy look stronger can be positive for the dollar and vice versa, though some of this is tempered by inflation expectations (some growth is good, too much growth is dangerous). Accordingly, traders need to pay careful attention to the scheduled releases of economic data like GDP, trade balances, inflation and so on. This data comes out at regular intervals and traders can not only find these numbers freely on the internet, but also the consensus expectations for these numbers.
In the time around 2011, the U.S. dollar was increasingly driven by concerns about the solvency of the U.S. and the government's apparent inability to address persistent deficits and growing debt. Traders bid up the dollar, the Congress seemed serious about balanced budgets and debt reduction, but extensive spending and easy money policies to facilitate global military action and domestic economic stimulus weakened the dollar and fueled a bull market in gold. (For more, see Drastic Currency Changes: What's The Cause?)
The U.S. dollar is also uncommonly driven by global events, both good and bad. History has shown that the dollar tends to strengthen in times of global chaos, be that war, political instability or economic instability. Conversely, when global conditions appear more peaceful and sanguine, traders tend to focus even more intensely on the relative economic health of the United States and look for diversification away from the dollar.
Unique Factors for the U.S. Dollar
The unique position of the U.S. dollar as the world's reserve currency cannot be ignored. The status of the dollar allows the U.S. to effectively export inflation, while also enjoying a lower interest rate on its debt. That absolves the U.S. of some of the consequences of its own decisions and allows the country to effectively "off-load" some responsibility. As other currencies become more popular as alternative reserve currencies, there is a risk of higher inflation and interest rates in the U.S., as well as a weaker demand for the dollar. (Discover how and why the U.S. dollar emerged as official currency in many foreign countries. For more, see The U.S. Dollar's Unofficial Status as World Currency.)
The U.S. dollar also holds a significant position in many other financial instruments. While trade between nations can be denominated in whatever currency is most convenient, many global markets are based upon the dollar, including gold, oil and many other commodities. The size of the U.S. financial markets also plays a role here; while other stock, option, commodity and bond markets outside the U.S. are growing, the size, liquidity, convenience and transparency of the U.S. markets make them attractive to global traders and buoy the role of the dollar in financial transactions. (For more, see How To Trade Currency And Commodity Correlations.)
The Bottom Line
Currency rates are notoriously difficult to predict, and most models seldom work for more than brief periods of time. While economics-based models are seldom useful to short-term traders, economic conditions do shape long-term trends.
With the weakness in the euro unearthed by the sovereign debt crises of 2008-2011, the U.S. dollar again has a preeminent position as a reserve currency and safe haven. Given that it is extremely unlikely that any major economy will readopt a gold-based currency system or that the Chinese want the yuan to become a major trading currency in the forex market, the dollar seems likely to keep its prime spot as a trading currency and global default currency.
That is not to say that it will continue to enjoy a rich valuation, though. The value of the dollar is going be determined by the economic health of the country and the ability of its government to address persistent deficits and growing national debt. That said, investors, speculators and traders should realize that the significance of the dollar divorces it from its intrinsic value and that perceptions of the dollar's hegemony will influence value alongside economic considerations. (For related reading, see Play Foreign Currencies Against The U.S. Dollar And Win.)