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This article is about the U.S Dollar Currency. You may also be looking for ETF ProShares Ultra Semiconductors (USD).
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|This article describes a currency traded on the global foreign exchange market. View articles referencing this currency.|
The U.S. dollar (USD) (also known as the Greenback or Buck) is the official currency used in the United States of America. 85% of all currency transactions across the world involve the US dollar. It is the world's primary reserve currency and 25 different currencies are pegged to the US dollar.
The dollar's value refers to the purchasing power of the dollar versus other currencies, or the exchange rate between the two currencies. When the dollar is strong, foreign goods are relatively less expensive. This can benefit businesses that import raw materials or manufactured goods into the United states, such as Wal-Mart Stores (WMT). A weakening dollar benefits companies with foreign competitors, such as US Steel (X), as their competitors' goods become more expensive. A weakening dollar can also lead to rising interest rates, as investors require higher rates to compensate for the added currency risk. Higher interest rates, in turn, have significant consequences for the housing market and business investment in general. A strong dollar means lower oil prices, as the US purchase much of its oil abroad. As the dollar weakens oil producers charge more to protect their margins.
The chart at left shows the exchange rate between the US Dollar and the Euro (EUR) - specifically, this chart is the number of Dollars per 1 Euro.
A trade deficit occurs when a country imports more than it exports. This leads to a net outflow of a country's currency. Countries on the other side of the transaction will typically sell the importing country's currency on the open market. As supply of the country's currency increases in the global market the currency depreciates. As a net importer, the US has seen its trade deficit grow rapidly over the last decade. In 2008, the United States had a record trade deficit of $816 billion dollars. This trade deficit weakens the US dollar relative to other currencies since foreign goods are denominated in foreign currency, thus demand for foreign goods increases the demand for foreign currency and decreases the demand for US dollars. This causes the US dollar to depreciate.
When a country's government spends more than it earns from taxes or other sources of revenues, it is forced to borrow from its citizens and/or from foreign entities. As a country's debt load increases, the value of its currency may decrease as result of fears within the international community over its ability to repay the debt. In addition, by borrowing money from foreign countries, the US increases the demand for foreign currency in exchange for US Bonds. The US is the world's largest debtor with approximately $12 trillion dollars in debt in total debt. Over half of this debt is owned by foreign countries and lenders.
Japan($349B) and China($643B) are two of the largest purchasers of US debt. China in particular has exhibited a voracious appetite for US debt. Its rapidly growing economy is heavily dependent on exports, and the US is one of its largest trading partners. In any given year, the US imports much more from China than it exports to China. As a result there is a net flow of dollars to China. Normally, one might expect China to sell these dollars on the global market, causing the dollar to weaken. Instead China reinvests its dollars in US debt. In doing so, China strengthens the US dollar and limits the appreciation of its own currency. Chinese exports remain cheap to American consumers.
However, due to large deficits many countries, China and India in particular, have begun to reconsider diversifying their reserves to protect themselves from a devaluation of the US Dollar. In November 2009, the Indian Central Bank announced that it would purchase $6.7B worth of Gold to diversify its reserves. China, which is the single largest purchaser of US Securities, has similarly increased its reserves of gold by 76% since 2003 and has hinted at further purchases. The decision of these large countries to shift increasingly towards Gold as a reserve currency greatly decreases the demand for US Dollars and weakens the USD.
Demand for a country's currency is highly dependent on the relative value of holding it, ie. the real, relative return of U.S. government bonds. Fear over higher inflation erodes the real value of bonds, which in turn decreases demand for US dollars. Similarly, tighter monetary policy raises the real interest rate on U.S. Gov. bonds, at which demand for US dollars increases until the relative, risk adjusted return on those bonds is equivalent to the return on bonds for another country. In the long run, exchange rates are heavily dependent on the relative inflation rates between countries. This is because an exchange rate is essentially the conversion between the price of buying one set of goods in two different countries. These relative price differentials is determined largely by the relative inflation rates in the two countries.
The Federal Open Market Committee, comprising of the Chairman, Vice Chairman, and three other members, along with the chiefs of the regional branches of the Federal Reserve System, come together regularly to determine the Federal Funds Rate, which is the rate at which financial institutions with deposits at the Federal Reserve lend to each other. The release of the decision is usually accompanied by much media fanfare, analysis and commentary, and with good reason. Lending at the federal funds rate is the normal channel for banks with financing needs, and it represents the wholesale market for large financial institutions.
The Federal Reserve Rate also determines the Dollar Libor rate which is the basis of many different types of financial transactions from complex derivative contracts, to credit card and mortgage interest rates. Libor is the cost of short-term unsecured interbank lending (where there’s no collateral exchanged between counterparties). As such, it is one of the building blocks of the modern financial system. Although most transaction in the unsecured market are limited to a single month at most, the benchmarks themselves are regularly quoted and taken as a basis for contracts and agreements.
The level of technology and production which a country has relative to other countries alters the exchange rates. Countries which are able to produce relatively well and/or have high levels of technology increase the demand for domestic investment and domestic goods. This rise in demand for both capital and goods strengthens the currency and the exchange rate. Thus, when the US is seen as a technological and production leader, high investment and purchasing rates keeps the US dollar relatively strong.
The most active USD trading hours are from London's opening market hours (2:00AM ET / 6:00 GMT) due to London's strength in international markets and the typical time of release for U.S. Economic news (8:30AM ET/ 12:30 GMT).
|FX Turnover by Currency Pair|
1. Interest Rates are Very Important for the Dollar. Take a look at how USD/JPY tracks the 3 Month LIBOR rate for the U.S.
2. Many Commodities are Priced in Dollars, so when the dollar rises, commodity prices fall:
3. Dollar Strength or Weakness frequently dominate the currency market on one given day, so know the risks of correlated positions! On March 21st the dollar strengthened against every single G10 currency.
Because the US Dollar is used more extensively in the United States, the US economy has a particular effect on the dollar. The demand and breakdown of goods in the United States effects the demand for the dollar and so its relative value. The U.S. Economy is comprised of 78% Services, 21% Industrial, and 1% Agriculture. It's largest trading partners are Canada, China, Mexico, Japan, and Germany. Some other key facts about the U.S. Economy:
|2008 GDP Estimate:||USD $14.29 Trillion|
|Trade Balance***||-USD $27.6B|
NOTE: These values are from, respectively: *As of June 2009 ** As of April 2009 *** As of March 2009
The market and the US Dollar are particularly effected by each of the following economic activities to varying degrees:
The U.S. Federal Reserve is the U.S. central bank responsible for determining what is arguably the most important variable defining forex trends and currency values: the main interest rate. Established in 1907 in response to a particularly severe banking crisis with bankruns and many failures, the institution was further strengthened with successive legislations, and made independent in 1913, and as such, its decisions do not need the approval of the Congress, the President, or any other authority. After the U.S. abandoned the gold standard in 1971, it acquired even greater influence and power under the successive administrations of Paul Volcker and Alan Greenspan.
The role and goals of the Federal Reserve are set out in the Federal Reserve Act where it is stated that the FOMC (the Federal Open Market Committee) must aim “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Since stable prices are generally accepted to be a precondition for sustainable growth and moderate interest rates, the FOMC implicitly targets an inflation level of close to, but below two percent while determining its main lending rate.
Most importantly, the U.S. Federal Reserve does not have a predetermined exchange rate target, nor does it aim to influence forex price fluctuations with its interest rate decisions. The Fed admits the importance of the stability of the exchange rate for inflationary expectations and domestic welfare, but explains that since the causes of currency fluctuations can be difficult to determine, targeting them with policy action would be misleading and counterproductive.
The Federal Reserve sets its main rate during meeting of the FOMC which are always anticipated with great excitement by market participants and the news media.
As part of the fractional reserve system, banks are required by law to hold a percentage amount as a deposit with the Federal Reserve to ensure liquidity in the system, and as an implicit sign that they are solvent. The Fed’s main rate, the Fed Funds Rate, is the interest rate at which banks are expected to trade these deposits among themselves. This is also the main rate which markets devote great attention to, since it is the cheapest money in the economy in terms of interest rates. The lower it is, the easier it is to pay loans, and the greater risk tolerance of borrowers.
As the lender of last resort, the Fed also offers to lend to financial institutions which are unable to acquire the necessary amount in the market due to temporary liquidity shortages. Ideally, the Federal Reserve is only expected to extend this aid to firms that are solvent, but illiquid, in that they are financially solid, but are temporarily constrained due to temporary problems, but this principle can be contravened in times of crisis. The discount rate is usually set about a hundred points above the Federal Funds Rate, but the Fed is authorized to reduce this difference in response to liquidity shortages.
The Federal Reserve’s main tool in maintaining interest rates close to the value declared at its monthly meetings (the Fed Funds Rate) is the “open market operations” tool used by Federal Reserve Bank of New York on a regular basis. By increasing or decreasing the amount of overnight liquidity in the market through repurchase agreements (repos or reverse repos), the Federal Reserve ensures that banks have access to liquidity at the cost determined at FOMC meetings.
The reserve requirement is another way of controlling the amount of credit available to the private sector. It is a somewhat more blunt tool in comparison to open-market operations, since it influences many financial institutions at the same time. As such it is used less often than the main tool and when used it is for purposes other than the management of liquidity.
In response to the economic turmoil of 2007-2009, the Federal Reserve has activated many supplementary programs and lending facilities in a bid to increase liquidity in the markets and prevent the financial markets from seizing-up. These new facilities are numerous, and are mainly used to expand the type and term of collateral accepted by the Federal Reserve beyond the risk-free government paper such as Treasury Bonds.