Currencies | Jul 26 2010
By Jennifer Gorton
The US Dollar is the most widely held currency in the entire world. Due to the fact that the Dollar is the world reserve currency, it trades more each day than any other currency in the FX Market. In this article, we will break down the key drivers of the US Dollar in order to understand its movement in recent market history and, more importantly, to get a clear picture of where the Dollar may be headed in the future.
Since currencies were removed from the gold standard in the 1970’s, the only thing that actually backs the value of a currency is the government that issues it. Thus, a currency that is issued by a government such as Iraq, does not tend to be trusted as much as a currency issued by a country such as England. And this very point is where the US Dollar derives much of its power. The US government is the most trusted government in the world. Due to our expansive governmental structure, our democratic and capitalist society, and our strong presence of checks and balances in the government, global investors still look upon the US as the safest investment in the world.
Risk Aversion
The market truth explained in the preceding paragraph is what drives the US Dollar during times of economic uncertainty. When investors become fearful due to the prospects of a deteriorating economy, they flock to the US Dollar. During these times of instability, investors will liquidate their positions in risky assets and place their capital in the ultimate safety of United States treasury bills, bonds, and other safe-haven US Dollar-denominated assets. This movement into safe-haven assets is referred to as a “flight-to-quality” move. Let’s take a look at what happened to the US Dollar versus the British Pound during at the outset of the 2008 Global Credit Crisis.
As the Sub-Prime Mortgage bubble officially burst in late August of 2008 with the failure of Fannie Mae and Freddie Mac, a degree of fear gripped financial markets that could only be expressed as complete hysteria. The fall of 2008 was an ugly time in America’s economic history. Equity markets plummeted, real estate values crashed, and credit dried up. It was ugly. One would think that when the US economy is in such bad shape that the U.S. Dollar would fall, but the exact opposite generally tends to occur—the US Dollar actually gets stronger. This is what the market refers to as a risk aversion play. When investors are averse, or opposed, to taking risk, they put their money in the US Dollar.
Risk Appetite
The economy finally bottomed out in March of 2009, and it began to rebound. The stock market began to climb back up, unemployment peaked out, and general economic conditions appeared to be improving. When investors became convinced in March of ’09 that the worst was over, and the recovery was under way, they began to take risk again. And when investors want to take risk, they take their capital out of the safe, but very low yielding Dollar and place it in riskier assets in order to get a better return. So, the US Dollar took a hit beginning in March of 2009.
This picture shows the weakness in the US Dollar beginning in March of ’09 as risk appetite came back into market.
The Current State of the US Dollar
The Dollar lost tremendous value between March of 2009 and November of 2009, but in November of 2009 a huge wave of risk aversion re-entered the market as it became evident that there was a serious threat of possible EuroZone default.
Now that the threat of default in Greece and other struggling EuroZone countries has been largely contained by fiscal austerity measures and a large bailout package designed by the European Central Bank and International Monetary Fund, investors have returned to risk, and the US Dollar is currently struggling. Good news has been coming out of Europe and the US during the latter part of July and investors are becoming more confident that, although the recovery is definitely slow, it is stable, and this is leading most investors, especially currency traders and Forex brokerages, to shirk the Dollar at the moment in search of higher yield.
The Future of the US Dollar
This is where it gets very interesting. As we have proven, investors tend to hold the US Dollar only during times of economic uncertainty. During times of economic stability no one wants to hold the US Dollar because of its very low yield versus other currencies. The future of the US Dollar is heavily dependent on its ability to retain its safe-haven status. If it ever loses this status, the US Dollar will be in for a huge time of reckoning. If investors don’t want to hold US Dollars during good times or during bad times, then when and who will hold US Dollars? No one.
Jennifer Gorton works for www.forextraders.com All views expressed are hers, not FNArena's (see our disclaimer).
