In our previous editions, we illustrated how the US dollar index measures the value of the dollar against a basket of six other foreign currencies. We learned that after the end of World War II, The Bretton Woods Agreement was established and the U.S dollar became the world’s reserve currency for international trading and finance. Nowadays, the dollar is used as the primary currency for trading between countries, and central banks continue to retain most of their reserves in dollars. Therefore, as with any other currency, the value of the dollar is greatly dependent on supply and demand dynamics in addition to the direction of monetary policies and the condition of the United States economy. Now let’s dive deeper into factors that affect the value of the dollar.
Supply & Demand (Reserves, Trade & Capital Markets)
The very fact that the US dollar is the world’s reserve currency, creates an automatic and natural demand for it. Countries all over the world need to accumulate dollar reserves to support their local currency, absorb external shocks, meet external debt obligations and foreign exchange needs and purchase key commodities, such as gold, wheat, and oil. The US also is one of the world’s largest exporters, and other countries pay for US products in dollars, while countries also primarily trade with one another in dollars. This constant and fixed demand always maintains the strong value of the dollar.
Strong demand for the dollar also stems from the capital markets, more specifically the bond market. As we had previously explained, countries sometimes need to issue dollar-denominated bonds and raise capital to fund their obligations. Sovereign bonds are considered a safe investment for foreign investors, who purchase these bonds, in dollars, which in turn creates high demand. The US government itself issues bonds to raise capital. Due to the US’s high credit rating, the strength of the currency, and increasing treasury yield, more and more investors flock to purchase US treasuries, which again keeps the demand and value of the dollar high.
Monetary Policy (Interest rates & Inflation)
The US Fed reduces interest rates to encourage investors from borrowing money and spending it, therefore helping boost economic activity, which may increase inflation. This means that lowering rates, therefore, creates higher inflation and can weaken the dollar, because the more dollars in circulation (supply) the less valuable it becomes. But again, even at times of high US inflation, natural demand for the dollar as described above can compensate for this upwards pressure caused by inflation.
At times of high inflation either resulting from supply side shocks increased prices or demand-driven inflation, interest rates are increased to discourage investors from borrowing, reducing the money supply to tame inflation. When the US government increases rates, yields on U.S bonds also increase, becoming more attractive for investors seeking higher returns. This then creates more demand for the dollar versus other lower-yielding currencies.
US Economic Outlook & Market Sentiment
The stronger the US economy, the stronger the dollar. Being one of the strongest economies in the world, the US remains attractive to investors. At times of crisis, when the US has not seen strong and consistent economic growth, the value of the dollar can sometimes slightly dampen, as investors become weary of a recession and a negative outlook. However, as we have seen recently the dollar remains at strong levels, even amidst a crushing global economic crisis, this again is due to the influence of the dollar as the world’s reserve currency. Moreover, the U.S. dollar is thought of as a safe haven at times of global economic uncertainty, so demand for it can often persevere despite fluctuations in the performance of the U.S. economy.