Understanding the Importance of the US Dollar in the Forex Market

Understanding the Importance of the US Dollar in the Forex Market

Reading time: 15 minutes

The foreign exchange market, or forex market, is the world’s largest financial market, with an average daily trading volume (OTC) of over $7.5 trillion (Bank for International Settlements). It operates 24 hours a day, five days a week, and is decentralised. The foreign exchange market comprises a global network of banks, corporations, and individuals trading currencies with one another. 

The Forex market is made up of currency pairs which express one currency in terms of another. For example, in the currency pair EUR/USD, representing the euro to the US dollar, EUR is the base currency (always situated on the left in a currency quotation), and USD is the quote currency (always on the right side of a currency pair’s quotation). If traders expect the euro to strengthen against the US dollar, they buy (or ‘go long’) in EUR/USD.

At its simplest, the forex market is driven by supply and demand. If more people want a particular currency, demand will increase and drive its price higher. Conversely, if a currency sees a drop in demand, its price will fall. 

Currencies traded in the forex market are categorised into three types:

  • Major pairs (e.g., EUR/USD, USD/JPY) feature the US dollar and are the most traded.
  • Minor (or ‘cross’) pairs (e.g., EUR/GBP, GBP/JPY) include a major currency but not the US dollar.
  • Exotic pairs (e.g., USD/SGD, GBP/ZAR) consist of a major currency and the currency of an emerging economy.

Importance of Currency Rates in Forex Trading

For each currency pair, there’ll be a currency rate (exchange rate). This rate expresses the value of one currency relative to another (e.g., £1 = $1.24) and constantly fluctuates due to the ever-evolving economic landscape. The goal of currency trading is to capitalise on these fluctuations in exchange rates. 

Various factors influence these exchange rates, like monetary policy, inflation, political stability, economic performance, and market speculation. For example, if a nation’s central bank hikes interest rates, its respective currency will typically strengthen due to a flood of investors seeking higher returns. In contrast, negative macroeconomic data, like high inflation readings, can drive investors out of a currency and weaken its value. 

History of the US Dollar

The US dollar, symbolised by $ and often called the 'greenback', has an intriguing history. Before its inception, the silver-based Spanish dollar was widely accepted in the Americas. During the American Revolution (1775-1783), the US started issuing Continentals, paper bills backed by the Spanish dollar, which eventually depreciated. 

In 1785, the Continental Congress approved the issue of a new currency, the US dollar, formally recognised by the Coinage Act of 1792. Throughout the Civil War (1861-1865), green dollar notes funded the war effort, prompting the name 'greenback'. However, it wasn’t until 1863 when The National Banking Act declared the US dollar the nation’s only legal tender.

Before 1900, the US dollar was backed by gold and silver, but the Gold Standard Act of 1900 established gold as its sole backing. During the Great Depression in the early 1930s, gold convertibility was dropped as President Roosevelt demanded gold coins, bullion, and certificates be exchanged for paper currency to fund the World War II effort.

The Bretton Woods Agreement of 1944 abandoned the Gold Standard globally, cementing the US dollar as the world's major reserve currency. It also marked the establishment of the International Monetary Fund (IMF) and World Bank. The US promised to redeem dollars for gold at a fixed rate, making it equivalent to gold. 

However, gold convertibility was suspended in 1971 in the Nixon Shock event, transforming the US dollar into a free-floating fiat currency, backed by faith in the US government. Since then, the dollar has remained the dominant global reserve currency.

The US Dollar as a Key Reserve Currency

A reserve currency is a currency held in large quantities by governments and financial institutions as part of their foreign exchange reserves. This currency is often used in global trade and finance, meaning its performance is closely watched. 

The US dollar’s status as the world’s reserve currency results from several factors. The US’ economic strength and stability, the size of its financial markets, and trust in US-based institutions have all contributed to the dollar’s strength over the past century. The Bretton Woods Agreement also gave it a significant boost on the world stage, pegging the currencies of many large economies, like Japan, the UK, and Germany, to the US dollar.

Perhaps one of the strongest factors behind the dollar’s dominance is its position as the ‘petrodollar.’ Oil is predominantly priced and traded in US dollars, meaning importing and exporting nations must hold it in their currency reserves. Given the universal demand for oil, this system has been crucial to the dollar’s global success story.

The US Dollar as International Cash

As the world’s reserve currency, the US dollar has become the natural choice for many international cash transactions. Its widespread acceptance and convertibility mean it’s not uncommon for individuals to hold their savings in dollars, especially in countries with runaway inflation.

For many travellers, the US dollar is their preferred currency. In countries with booming tourism industries or a volatile local currency, the dollar is readily accepted by merchants.

In fact, some countries have even adopted the US dollar as their official currency, in a process known as dollarisation. 11 countries, including Ecuador, El Salvador, and Zimbabwe, accept the dollar as legal tender. Others peg their currency to the dollar at a fixed exchange rate, typically in oil-producing Arab nations, like Saudi Arabia and Oman, because of the dollar’s association with international oil trade. 

Role of the US Dollar in International Financial Transactions

The US dollar’s widespread acceptance means it’s deeply embedded in cross-border financial transactions. In international trade and commerce, it helps to simplify transactions by using one common currency. Commodities, like oil, gold, and grain, are also commonly priced and exchanged in dollars for this reason. 

Moreover, the dollar is the primary currency held in foreign currency reserves by monetary authorities, accounting for roughly 54% of global reserves (International Monetary Fund). Using the US dollar, these institutions are effectively guaranteed a certain level of liquidity and stability, which helps the global financial system run smoothly.

The dollar’s position in world trade also makes it integral to the financial sector, particularly banking. According to the Federal Reserve, around 60% of international currency liabilities (primarily deposits) and claims (mostly loans) are denominated in US dollars. The World Bank and IMF - two critical global players - typically offer national loans in dollars. It’s also common to see foreign and corporate bonds issued in US dollars.

The Significance of the US Dollar in the Forex Market

Its relevance to the financial sector and trade means that the US dollar plays an outsized role in the forex market. The dollar is the most traded currency, ahead of the euro, involved in 88% of all transactions (Bank for International Settlements). In other words, it makes up roughly $6.6 trillion of the $7.5 trillion transacted each day.

As mentioned earlier, a set of major currency pairs account for most of the market’s volume and feature the US dollar. These pairs include the following currencies:

  • Euro (EUR/USD)
  • Japanese yen (USD/JPY)
  • British pound (GBP/USD)
  • Australian dollar (AUD/USD)
  • New Zealand dollar (NZD/USD)
  • Swiss franc (USD/CHF)
  • Canadian dollar (USD/CAD)

Any changes in the US economy or monetary policy can have far-reaching effects on these currency pairs and, by extension, the entire forex market. You’ll often see important economic events from the US, like GDP data or interest rate decisions, impact seemingly unrelated pairs, like GBP/JPY.

A Review of the US Dollar's Performance in the Forex Market

The US dollar's performance in the forex market has been marked by periods of strength and weakness, driven by both regional and global events. The chart above shows the US dollar index or DXY.

In 1973, shortly after moving away from the Gold Standard, an oil crisis caused by OPEC's embargo prompted exceptionally high inflation and a weak dollar. In contrast, Reagan's aggressive interest rate hikes in the 1980s strengthened it.

In 1985, major economies, including the US, Germany, Japan, and the UK, signed the Plaza Accord to address the exceptionally strong dollar, which was contributing to a sizeable current account deficit and a recession following the oil crisis. Central banks conducted deliberate market interventions, leading to the steep drop in the chart shown. 

As the Asian Financial crisis of 1997-1998 set in, the dollar rose as investors flooded into safe-haven assets, a trend that briefly continued after the 2000 dot-com bubble. However, as the Fed cut interest rates to stimulate growth, the dollar fell again.

In a crisis much closer to home, the global financial crisis of 2008 saw the value of the US dollar fall initially. As investors sought a safe haven, it quickly strengthened but fluctuated in the following years due to concerns about the US economy and its loose monetary policy. The early 2010s' strong economic growth and subsequent expectations of higher interest rates further strengthened the dollar.

After fluctuating between 2015 and 2020, the US dollar faced a new challenge: the COVID-19 pandemic. While it initially strengthened, Federal Reserve's interest rate cuts, aimed at stimulating the economy, led to a decline throughout 2020 and early 2021. As inflation soared to its highest rates in over 40 years, higher interest rates boosted dollar demand and its value. 

Exploring the Relationship Between International Lending Policies and the US Dollar

Many international loans are denominated in US dollars. When countries borrow in dollars, they must also repay in dollars, leading to ongoing demand for the dollar. However, loans from the US converted into foreign currencies can increase the supply of dollars on the forex market, potentially weakening its value. 

Ultimately, the Federal Reserve Bank and its monetary policy decisions have the greatest effect on this relationship. When the Fed lowers interest rates, it can lead to an increase in dollar-denominated loans and demand for the dollar as borrowing costs decrease, and vice versa. This is why the differences between interest rates in the US and other nations are often the primary driver behind a dollar-based currency pair’s exchange rate.

What Would Happen to the Forex Market Without the US Dollar as Its Leading Currency?

While the US dollar has shaped the global financial system for almost a century now, it’s frequently been speculated that the dollar is on its way out, often during times of crisis. In recent years, speculation has once again picked up due to trends in de-dollarisation, notably in China and Brazil. 

Without the dollar as its leading currency, there would likely be considerable long-term volatility in the forex market. Currently, the US dollar helps stabilise the markets due to its widespread acceptance and deep liquidity. Without it, global markets would likely experience significant uncertainty and instability for many years. Nations holding large amounts of US dollars could scramble for the exit door, sending its value plummeting.

Other major currencies, like the euro or China’s renminbi, could fill the void. This would not only likely disrupt the global economy for many years but may even lead to the rise of a new currency altogether.

Interestingly, international loans denominated in dollars would become easier to repay if the dollar weakened considerably, which may boost emerging markets and their respective currencies. The US government's own debt would also be cheaper to service, potentially easing its debt burden.

Interested in Trading the US Dollar with FP Markets?

With FP Markets, a leading Forex and CFD brokerage, traders and investors can access over 70 popular currency pairs, including the US Dollar Index (USDX). With competitive spreads and leverage up to 500:1, FP Markets provides a wide selection of Trading Accounts and Trading Platforms, such as MetaTrader 4 (MT4), MetaTrader 5 (MT5) and cTrader. 



Start Trading
in Minutes

bullet Access 10,000+ financial instruments
bullet Auto open & close positions
bullet News & economic calendar
bullet Technical indicators & charts
bullet Many more tools included

By supplying your email you agree to FP Markets privacy policy and receive future marketing materials from FP Markets. You can unsubscribe at any time.

Source - cache | Page ID - 34989

Get instant Updates in Telegram