Lesson 4: Factors That Will Determine if the US Dollar Remains King
Lesson 4: Factors That Will Determine if the US Dollar Remains King
In our last lesson we continued our free forex trading course with a look at why the US Dollar is still king of the currency world. As expected, this lesson generated a lot of debate, so in today's lesson we are going to look at whether or not the US Dollar will remain the king of the currency world.
As we discussed in our last lesson the US Dollar is involved in approximately 89% of all forex transactions, so the fate of the US Dollar has huge implications not only on the US Dollar, but on the forex market as a whole. While currently the US Dollar is still king of the currency world, many argue that the tides are changing, and that the US Dollar is in danger of losing this status. Whether or not this happens, to what extent it happens, and if it does happen how quickly or slowly it happens, is of huge importance to currency traders.
The most important reason why the US Dollar is king of the currency world is the fact that, as we learned about in our last lesson, it is the world's reserve currency. According to Wikipedia.com, as of 2007 there is approximately $7.5 trillion worth of currencies held as reserves by central banks around the world. Of that $7.5 trillion 63% or 4.7 trillion is held in US Dollars. This is an enormous amount of dollars being held by central banks outside of the United States, so forex traders watch closely anything that could show a decrease in the appetite of central banks for US Dollars.
Like with individuals and companies, other countries willingness to lend money to the United States (by holding US Dollar Denominated Debt as reserves) is based on the financial soundness of the United States as a whole. As we learned about in module 3 of this course, the US has run a large current account deficit for years. In addition to this, the country's government has also run large budget deficits. Like an individual who runs up large amounts of debt, this makes the debt of the United States less attractive, and has the potential to decrease other countries willingness to fund these activities, by holding US Dollar Denominated debt as reserves.
Secondly, many consider the monetary policy of the United States to be flawed, citing the Federal Reserve's increase of the money supply to hold interest rates low, as a major factor in the dollar's decline. As we learned about in our lessons in module 3 of this course, the lowering of interest rates tends to weaken the value of a currency all else being equal. As the value of the currency falls, countries around the world who hold that currency, see wealth evaporate due to the falling value of their reserves. This obviously has the potential to make the US Dollar less attractive for them to hold as their reserve currency, which means a decrease in demand, and a decrease in the value of the currency all else being equal.
As of this lesson the US Dollar has fallen over 35% in the last several years, as measured by the US Dollar Index. As we just discussed, this decreases the wealth of the countries who hold the US Dollar as their reserve currency, and has the potential to reduce their appetite for US Dollars, regardless of the reason for the decline in value. This potentially means a decrease in demand from the central banks to hold US Dollars as their reserve currency, and a decrease in the value of the currency, all else being equal.
US Dollar Index
With these three factors in mind, traders will watch carefully anything they feel will affect the willingness of other countries to continue to accumulate and hold the US Dollar as their reserve currency. Most importantly here are statements from any central bank or government officials in regards to this. While a statement from potentially any country in support of the US Dollar, or that they are diversifying away from the US Dollar has the potential to move markets, traders are especially sensitive to any hints from the largest holders of US Dollars which are listed here:
The final factor which people point to as a reason why the US Dollar may lose its status as king of the currency world, is because of the rise in prominence of the EURO, and its relative strength in comparison to the dollar. Before the introduction of the EURO, there was not really another currency which had the potential to compete on the same level as the dollar, as the reserve currency of the world. The famous former chairman of the US Federal Reserve Alan Greenspan, has even been quoted as saying: "it is absolutely conceivable that the EURO will replace the dollar as reserve currency, or will be traded as an equally important reserve currency." As you can see from the chart below, while the EURO still comes no where close to the US Dollar's dominance as the world's reserve currency, it is slowly gaining ground on the Dollar, an important point traders will be watching.
That's our lesson for today. In our next lesson we will look at other factors which can give us clues as to whether or not the US Dollar will remain the king of the currency world and how this can alert us to potential trading opportunities.
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