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The Importance of the U.S. Dollar

Everything we do in our lives is related to one currency, and one currency only: the U.S. dollar. Present times are dependent on what the dollar is doing no matter where we are in the world.

This may seem like an overstatement, but it is not. The entire financial system as we know it today is based on the U.S. dollar.

In 1944 the Bretton Woods summit market the beginning of a new financial order and the pillar was the U.S. dollar. To this day things are the same, more than seventy years later.

Something did change, though: the monetary policy and the amount of money in circulation used to be backed by gold. That is, central banks had to have a specific amount of gold in their vaults for every piece of bank note that was created.

The very concept of fiat money (paper money – the name comes from Fiat Lux, in Latin, Let There Be Light) is a delicate one, and the idea was to back the paper money with gold. It functioned very well until it stopped.

Governments around the world were forced to drop the gold system as debt piled more and more. Running a deficit is not an easy task, and financing one with a gold system in place is impossible.

Even tough gold is not part of the financial system at this very moment, the dollar still is. This didn’t change and won’t change in the foreseeable future.

The U.S. Dollar

Say you live in Austria, a European country. The currency now is the Euro, as Austria is a European Union member and is part of the Eurozone (countries that share the same currency, the Euro).

The world today is interconnected in ways we couldn’t imagine a few years ago. Think of smartphones, the Internet, the cloud, and other things that now are so common and we take them for granted.

They were revolutionary. They made communication much easier, faster, and, thus, trade flourished.

Globalization is a reality, like it or not, and if there’s a currency to reflect that, that is the U.S. dollar. If the Federal Reserve of the United States is changing the interest rate or just hints of a possible monetary policy change, the shockwaves sent throughout the world will have an influence on everyone. Including the ones living in Austria, a Eurozone member.

The World’s Reserve Currency

After the Bretton Woods, the U.S. dollar became the world’s reserve currency. To this day, it is not clear if this is a privilege or a burden for the U.S. economy.

There are logical arguments on both sides, but the truth is that every worldwide transaction, in the end, must be cleared in dollars. Oil is traded in dollars, to give you a simple example.

Political changes and influences made room for some exceptions, the so-called swap agreements. In a swap agreement, some goods can be paid in a different currency if the two parties/countries agree to do that.

Again, it is just an exception, as, in the end, prices will be denominated in the world’s reserve currency: the U.S. dollar. Isolated agreements cannot change that.

The Federal Reserve System

The Federal Reserve of the United States (Fed) is, in many ways, the world’s central bank. Even though the Bank of International Settlements in Basel, Switzerland, holds the role as the “mother of all central banks”, the Fed’s importance come from the fact that it decides the fate of the dollar.

If the Fed sneezes, the world catches a cold. If the Fed hikes the federal funds rate, the dollar will appreciate and the implications around the world are tremendous.

Imagine the emerging markets, for example, that used to fund their deficits with loans that are denominated in dollars. Higher interest rates in the United States will translate into more to be paid for those loans. For this reason, and not only, setting the monetary policy for the dollar is a difficult task the Fed has. Communicating to market participants such an intention is even more difficult.

The Fed’s ruling body, the Federal Open Market Committee (FOMC), is meeting every six weeks to assess the economy and set the proper monetary policy. In between these meeting, every three weeks after the FOMC meeting, the FOMC Minutes are made public.

US dollar FOMC Fed

These minutes show what the discussions were at the previous FOMC meeting, how many hawks or doves are on the committee, and so on. Moreover, between two FOMC meetings, Fed members are scheduled to speak at various conferences, TV interviews, newspapers, radio shows, etc.

Forward guidance is a principle introduced for the first time by the Fed and the idea is to communicate a monetary policy decision so well that there will be no shocks in the financial world. The March 2017 rate hike is the perfect example.

A rate hike at the March meeting was 100% priced in. It means the Fed used all the available communication tools to signal a hike is coming.

And it did. Under normal circumstances, a rate hike is bullish for the respective currency, only this time the dollar depreciated among its peers.

EURUSD, GBPUSD, AUDUSD and other pairs jumped on the news. This shows that the market was focusing on something else, and the Fed’s move was already discounted.

When the Fed is starting a tightening cycle or eases the monetary policy, the other major central banks in the world will follow suite. It is rare that there is a divergence between different central banks jurisdictions.

If there is one, it is only quantitative, not qualitative. That is, if the rates in the United States are rising, they will rise in other parts of the world as well, even though not with the same amount.

The financial system as we know it today is not mandatory to still be in place a hundred years from now. As a matter of fact, history tells us that, in this form, it is unlikely to last forever.

Sooner or later, some changes need to be made to accommodate for the latest developments and changes in the world. No matter the changes, the U.S. dollar will still play an important role on any new financial system to come.

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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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