By Brian Perry

The United States and the European Union are the two largest economic entities in the world. The U.S. dollar is the world's most heavily traded and most widely held currency. The currency of the European Union, known as the euro, is the world's second most popular currency. Because it is made up of the two most popular currencies in the world, the EUR/USD is the most actively traded currency pair.

The United States Economy

The United States is the largest national economy in the world, with a gross domestic product (GDP) of nearly $14 trillion. The U.S. economy is largely service-based, although high-end manufacturing still makes up approximately 15% of GDP. When economic activity in the United States is strong, the dollar generally strengthens; when economic activity slows, the dollar usually weakens. Because the United States is also considered a safe haven, the dollar tends to rise during times of global financial or political turmoil. U.S. policymakers have historically favored a strong dollar, and the U.S. Treasury sometimes intervenes in the currency markets if the dollar is perceived as too weak. (Also see The Fundamentals Of Forex Fundamentals.)

The Unique Role of the U.S. Dollar
The U.S. dollar plays a unique role in the world of international finance. As the world's reserve currency, the U.S. dollar is used to settle most international transactions. When global central banks hold foreign currency reserves, a large portion of those reserves is often held in U.S. dollars. In addition, many smaller countries choose either to peg their currency's value to that of the U.S. dollar or forgo having their own currency, choosing to use the U.S. dollar instead. The price of gold (and other commodities) is generally set in U.S. dollars, too. Not only this, but the Organization of Petroleum Exporting Countries (OPEC) transacts in U.S. dollars. This means that when a nation buys or sells oil, it buys or sells the U.S. dollar at the same time. All of these factors contribute to the dollar's status as the world's most important currency.

Not surprisingly, the U.S. dollar is the most heavily traded currency. Most foreign currencies trade against the U.S. dollar more often than in a pair with any other currency. For this reason, it is important for investors interested in the currency markets to have a firm grasp of the fundamentals of the United States economy and a solid understanding of the direction in which the U.S. dollar is going. (To learn how to profit from a falling dollar, see Taking Advantage Of A Weak U.S. Dollar.)

The European Union Economy
Altogether, the European Union represents the world's largest economic region with a GDP of more than $14 trillion. Like the United States, the economy of Europe is heavily focused on services, although manufacturing represents a greater percentage of GDP than it does in the United States. When economic activity in the European Union is strong, the euro generally strengthens; when economic activity slows, the euro usually weakens.

Why the Euro Is Unique
While the U.S. dollar is the currency of a single country, the euro is the single currency of 16 European countries within the European Union, collectively known as the "eurozone" or the European and Economic Monetary Union (EMU). Disagreements sometimes arise among European governments about the future course of the European Union or monetary policy. When these political or economic disagreements arise, the euro typically weakens. (To learn more about why the euro is so important, see Top 8 Most Tradable Currencies.)

Factors Influencing the Direction of the EUR/USD
The primary factor that influences the direction of the euro/U.S. dollar pair is the relative strength of the two economies. With all other things being equal, a faster-growing U.S. economy strengthens the dollar against the euro, and a faster-growing European Union economy strengthens the euro against the dollar. One key sign of the relative strength of the two economies is the level of interest rates. When U.S. interest rates are higher than those of key European economies, the dollar generally strengthens. When eurozone interest rates are higher, the dollar usually weakens.

Another factor that can have a strong influence on the euro/U.S. dollar relationship is political instability among the members of the European Union. The euro currency is unique in that it is a common currency for 16 European nations. The euro, introduced in 1999, is also relatively new. This makes the eurozone, in some respects, an experiment in economic and monetary policy. As the countries within the eurozone learn to work with each other, differences sometimes arise. If these differences appear serious or potentially threatening to the future stability of the eurozone, the dollar is likely to strengthen against the euro.

The list below shows the current members of the eurozone as of January 1, 2009. When trading the euro/U.S. dollar pair, investors should carefully watch for troublesome economic and political news originating in the area. If several eurozone countries have weakening economies, or if newspaper headlines are discussing political difficulties among the countries in the region, the euro is likely to weaken against the dollar

Members of the Eurozone
    • Austria
    • Belgium
    • Cyprus
    • Finland
    • France
    • Germany
    • Greece
    • Ireland
    • Italy
    • Luxembourg
    • Malta
    • Netherlands
    • Portugal
    • Slovakia
    • Slovenia
    • Spain
Trading the EUR/USD
Because the euro and U.S. dollar are the world's two largest currencies from the world's two largest economic and trading blocs, multinational corporations typically conduct business in both the United States and Europe. These corporations have an almost constant need to hedge their exposure to the risk of currency movement. Some firms, such as international financial institutions, have offices in both the United States and Europe. These firms are also constantly involved in trading the euro and the U.S. dollar.

Because the euro/U.S. dollar is such a popular currency pair, arbitrage opportunities are not often available. However, investors still enjoy trading the pair. As the world's most liquid currency pair, the euro/U.S. dollar offers very low bid-ask spreads and constant liquidity for traders wanting to buy or sell. These two features are important to speculators and help contribute to the pair's popularity. Furthermore, the large number of market participants and the availability of economic and financial data allow traders to constantly formulate and reassess their positions and opinions. This constant activity provides for relatively high levels of volatility, which can lead to opportunities for profit.

The combination of liquidity and volatility makes the euro/U.S. dollar pair an excellent place to begin trading for newcomers to the currency market. However, it is always necessary to understand the role of risk management when trading currencies or any other kind of instruments. (For more information, see Forex: Money Management Matters.)


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