Why Does The Dollar Impact The Entire Forex Market?

The dollar is considered the global reserve currency. It is the most sought-after currency and is used throughout the world for commerce. According to the Bank of International Settlements, about 88% of all forex trading includes the U.S. dollar on one side of a trade. The forex market is the largest and most active of all the capital markets. Trading in the over-the-counter forex market reached 7.5 trillion dollars daily as of Q1 2022. This figure is up from 6.6 trillion in average daily turnover in the year prior. According to the Bank of International Settlements, forex swaps accounted for 51% of the total volume from 49% in the prior year.

The majority of the trading took place in five jurisdictions. These included the United States, The United Kingdom, Hong Kong, Singapore, and Japan. According to the data provided by the Bank of International Settlements, there was an acceleration in the trading activity in both the United States and Singapore in the latest survey. The dollar plays a significant role in forex trading activity, and changes to trade and monetary policy were likely the catalysts during the period ending April 2022.

What is a Reserve Currency

The dollar is considered the global reserve currency. A reserve currency is a currency that is widely held and used by governments, central banks, and other multinational institutions for international transactions, investments, and as a store of value. It is typically a stable and trusted currency that serves as a benchmark for global trade and finance. The primary role of a reserve currency is to provide stability and confidence in the global financial system, facilitating international trade and investment flows. Historically, the U.S. dollar has been the dominant reserve currency.

Countries often use reserve currencies for several reasons. A reserve currency facilitates international trade by providing a common medium of exchange. It simplifies forex trading and reduces the need for currency conversions, making it easier for countries to engage in global commerce.

Stable and credible countries or monetary authorities typically issue reserve currencies. By adopting such a currency as a reserve, countries gain access to a stable and reliable store of value. This situation can help foster confidence in their currency and stabilize their domestic financial system.

Holding reserves in a widely accepted currency can enhance a country's credibility and reputation in the global economy. It demonstrates the country's ability to maintain monetary stability and instill confidence in investors and trading partners.

Reserve currencies, particularly those with profound and liquid financial markets, offer countries access to a broader pool of capital. This situation can help fund public expenditures, support economic growth, and provide a safety net during economic uncertainty.

Holding reserves in a different currency can act as a hedge against exchange rate fluctuations. This scenario can help mitigate the impact of currency volatility on a country's currency, particularly during economic or financial turbulence.

The Dollar is the Most Widely Used Currency for Trade

The U.S. dollar plays a significant role in forex trading. The dollar is the most widely used currency for international trade and is involved in many global transactions. This widespread use creates a high demand for foreign exchange dollars.

The U.S. dollar is frequently seen as a safe haven currency. During times of uncertainty or market volatility, investors often flock to the relative stability and liquidity provided by the U.S. dollar. This increased demand can drive up the dollar's value in forex trading. Due to these factors, the U.S. dollar's importance in global trade, worldwide currency reserves, economic influence, and safe haven status all contribute to its central role in forex trading.

The Dollar is Essential to Major and Minor Currency Trading

Most of the trading that occurs is major currency trading. Major currency trading refers to trading the most frequently traded currencies in the forex market. These currencies are often referred to as "major" or "major pairs" and include the U.S. dollar (USD), Euro (EUR), Japanese yen (JPY), British pound (GBP), Swiss franc (CHF), Canadian dollar (CAD), Australian dollar (AUD), and New Zealand dollar (NZD).

Major currency pairs are the most liquid and actively traded pairs in the forex market. They represent the largest economies in the world and generally have the highest trading volumes. Trading major currency pairs provides traders ample liquidity, tighter spreads, and more significant market analysis and price movement opportunities.

Economic and political developments highly influence major currency trading in the countries that issue these currencies. Economic indicators, central bank decisions, geopolitical events, and other factors can impact the value of these currencies and create trading opportunities.

Many forex traders focus on major currency pairs due to their popularity, liquidity, and availability of market information.

Minor currencies and exotic currencies are terms used in the foreign exchange market to refer to currencies that are not widely traded or are from economies that are considered smaller or less developed.

These currencies still have significant trading volumes but are not as liquid or widely accepted as the major currencies. Exotic currencies are less frequently traded and often originate from emerging markets or economies with limited international exposure. These currencies may have restrictions on their convertibility or be subject to higher volatility and risk.

What has Recently Impacted the Dollar, and How Does that Impact Other Currencies?

Changes in interest rates set by the Federal Reserve can significantly affect the exchange rate. Higher interest rates tend to attract foreign investment, increasing the demand for the U.S. Dollar and strengthening its value. During the past 18 months, there has been a significant change in the dollar value relative to other currencies due to changes in the Federal Funds rate controlled by the U.S. central bank. Interest rates have increased by 5% during this period making the dollar an attractive asset.

Inflation rates impact the value of a currency. Lower inflation typically strengthens a currency's value, while higher inflation can weaken it. Central bank policies that aim to control inflation play a crucial role in determining exchange rates.

The overall health of an economy can influence its currency. Strong economic growth, low unemployment rates, and stable fiscal policies generally lead to a strong currency, while recessionary conditions or fiscal instability may weaken it.

Political stability, policy certainty, and geopolitical developments can impact currency exchange rates. Uncertainty or political unrest can lead to volatility and weaken a currency.

The balance of trade and capital flows between countries can affect exchange rates. If a country runs a trade surplus, its currency may be in higher demand, strengthening its value. Conversely, a trade deficit may lead to a weaker currency.

The U.S. is the Largest Global Economy

The currency of the largest economy can also hold a lot of sway. The U.S. is the largest economy in the world. The U.S. has long held this position as it possesses a highly developed and diversified economy with significant contributions from various sectors such as technology, finance, manufacturing, and services.

The United States economy is driven by capitalism. Capitalism is an economic system characterized by private ownership of resources and means of production, where individuals and businesses operate for profit. In a capitalist system, goods and services are produced and distributed based on supply and demand in a free market. The government's role is usually limited to protecting property rights, enforcing contracts, and providing a framework for fair competition. Capitalism often promotes innovation, investment, and individual freedom but also comes with challenges like wealth inequality and occasional economic instability.

The U.S. also has many trading partners, which propagates the dollar. Capitalism also fosters resource allocation based on market demand and supply. Through the price mechanism, consumers' preferences are communicated to producers, helping to determine what goods and services should be produced and in what quantities. This flexibility allows a diverse range of products and services to be available, catering to various consumer needs and wants.

Additionally, capitalism tends to protect individual rights and private property, which can lead to greater personal freedom and economic opportunity. People can start businesses, invest in ventures, and choose their employment and consumption based on their preferences and abilities. This individual agency can drive innovation and create economic growth. This mechanism allows companies worldwide to use the dollar to deal with the United States.

The Bottom Line

The dollar is the most widely traded currency, with more than 88% of transactions occurring in the forex market containing the dollar. There are several reasons the dollar impacts the currency markets. The dollar is often used as a safe haven and a reserve currency that reduces the volatility of certain countries' currency reserves. The United States is the world’s largest economy; therefore, the dollar is spread to most of its trading partners. Movement in the dollar exchange rate will generally impact other currencies.

(This article is part of IndiaDotCom Pvt Ltd’s Consumer Connect Initiative, a paid publication programme. IDPL claims no editorial involvement and assumes no responsibility, liability or claims for any errors or omissions in the content of the article.)