The United States Dollar ($) is the most actively traded currency in the financial market. This year, the dollar has gained significantly against all the major currencies especially those from the emerging and developing world. The dollar index which measures the strength of the dollar against the major currencies is now trading at its highest levels in 5 years.
5 year chart of the dollar index
For investors, the strength of the dollar is of major concern as it leads to significant disadvantages especially in the emerging markets. In fact, many American companies with exposure in the emerging markets have suffered huge losses because of the weakening local currencies. On the other hand, the increased strength leads to increased predictability in the market.
Inverse relationship with gold
The US dollar and gold have had a unique inverse relationship as seen in the chart below. This means that when the dollar rises, gold responds by falling and vice versa. This is attributed to a number of factors. One, when the dollar falls, investors use gold as a safe haven to protect their investments. In cases of uncertainties and volatility, investors run to gold. Prior to 911many people preferred to keep their investments in US dollar because of their view that the United States was a safe country. Another reason why this happens is that gold is valued or measured in dollar terms. As a result, the dollar depreciation as a result of global uncertainties leads to increase demand for gold which in turn increases the prices of gold.
Inverse relationship of gold and US dollar
Over 90% of currency deals involve the dollar
The dollar is the most common currency today. 90% of all trade deals globally are measured in terms of the dollar. As a result, liquidity in the markets involving the dollar is always high. The most liquid currency pairs are: EURUSD, AUDUSD, USDCAD, and USDCHF. As a result of this, the demand for the dollar is usually high especially in international trade. In fact, most countries measure the health of their economies in dollar terms because United States is among the leading importers of products used in most countries.
Emerging countries peg on dollar
Another important detail about the United States dollar is that most countries especially those in the emerging markets peg their currencies to the dollar. Pegging a currency against the dollar is whena government maintains the U.S dollar as a reserve currency. They do this by accepting to buy and sell the dollar at a price that has been pegged. In addition, the central banks promise to hold the reserve currency which is equal to the amount of local currency in circulation. As a result, these central banks have become the largest holders of the dollar. Some of the countries that have pegged their currencies against the dollar include: Bahrain, China, Eritrea, and Djibouti. When a major country removes the peg on the dollar, the events are tragic to the investment community. Early this year, the Swiss National Bank removed the peg of Swiss Franc from the Euro and the results were tragic. Billions of dollars were wiped away from the financial market.
Relation to the stock market
The dollar is impacted by the stock market. Historically, the dollar has always been strong when the stock market and the economy is doing well. When the United States’ economy is doing well against the emerging and developing world, investors who have previously invested internationally return their money back to the United States. They do this to avoid the weakening markets which has the capabilities of weakening their stake in dollar terms. Therefore, the increase in demand for the dollar leads to an increase in its price.
As a trader, betting against the U.S dollar is always risky especially when you are doing so speculatively. Many experts believe that hedging is the best strategy to trade against the dollar especially with gold. However, when the macroeconomic indicators are not supporting the dollar, you can comfortably short the dollar.