Reasons For the Strong Dollar and How to Trade it – Introduction
The dollar is the reserve currency of the world. A reserve currency is simply a currency that is accepted in all countries around the world. With the dollar, you can buy anything in all countries. On the other hand, with currencies like Uganda Shillings, Turkish Liras, and Brazilian Real, it is impossible to buy products in other countries. The other most common currencies you can use to shop with are Japanese Yen, Euro, and Pound. However, the dollar makes up more than 64% of all reserve bank currencies in the world.
The dollar is printed by the Federal Reserve, which is the most important central bank in the world. This is because, the bank can limit the supply of the currency or even flood the market with it. To increase the value of the dollar, the Fed can increase interest rates and to lower its value, it can easily lower rates. In addition to lowering rates, the bank can use other tools.
A stronger American economy is very important for the dollar. This is because all countries with dollar reserves want to be sure that the economy is in good shape. No country wants to invest or have reserves for a worthless currency.
In recent months, the dollar has continued to gain strength. Its strength is attributed to a few factors.
First, after the financial crisis of 2008/9, the Fed lowered interest rates in a bid to spur growth. This trend was repeated by all the major central banks. Their logic was simple. At a time when the economy has crashed, lowering borrowing costs will incentivise people to borrow more which will in turn boost the economy.
In recent years, the Fed has moved to gradually raise interest rates. They believe that the economy is strong enough to withstand more hikes. This makes sense because, with the economy growing, the Fed has a responsibility to prevent it from overheating. An economy that is overheating presents risks of a hard landing when the economy develops some problems.
As the Fed has moved to raise interest rates, the other central banks have continued to support their currencies. The Bank of Japan has continued with negative interest rates and huge stimulus and the ECB plans to raise rates next year. The Bank of England raised rates last week but didn’t give indications of future rate hikes. Other major central banks have left rates unchanged. This leaves the dollar as the only high-yielding currency.
Second, the American economy has continued to strengthen. Just last week, the labour department reported that the second quarter GDP rose by 4.1%, the fastest growth rate since 2014. The economy is adding an average of 200K jobs per month, the unemployment rate has fallen to 4.1%. manufacturing jobs are coming back, and the jobless claims have continued to fall. All these factors support gradual rate increases which in turn leads to a higher dollar.
As a trader, you can trade the stronger dollar in a number of ways. First, you can ride the wave of the dollar by just buying the dollar and selling the other currencies. Second, you can trade in assets that have correlations with the dollar. For example, a stronger dollar leads to a weaker gold and other commodities. You can short these commodities.
However, there is a likelihood that the stronger dollar will not last for long. As the Fed starts to pause on interest rates and as other central banks start to wind down their stimulus packages, there is a possibility that the dollar will be an under performer.