How much is the dollar worth today? This is one of the most trending Google searches today. And the answer to it gives us a clue about the strength of the national currency. It also offers traders a chance to make money on it.
So, the question is, what does the exchange rate of the U.S. dollar depend on? Why is it essential? And how do we make use of this information in order to make a profit in the financial markets? Keep on reading to find out.
1. How much is a dollar worth in the foreign exchange market
2. What does the dollar exchange rate depend on
3. What affects the dollar
4. Carry Trade Strategy
The U.S. dollar is a freely convertible currency. Its exchange rate is shaped by means of free-market pricing. When we ask how much the dollar costs, the figure mentioned is the exchange rate of this currency against another currency e.g. Euro, British Pound, Japanese Yen, etc.
There is a tool called Dollar Index (DX) which is used to measure the average value of an American dollar against a basket of six world currencies. The composition of the currency basket and the share of each currency in the weighted average cost of the dollar:
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We have already figured out how much the dollar is worth against the basket of currencies. There are two aspects the value of the dollar depends on in each country (i.e. in each specific currency). These are:
1. The value of the currency we use to purchase the dollar with. In essence, this is its purchasing power. In other words, the cheaper the currency, the more expensive the dollar will be, and vice versa.
2. The value of the U.S. dollar itself. Its exchange rate depends on both internal factors (the Central Bank’s monetary policy) and external, market ones.
The second aspect is more relevant since it is able to give the cue regarding the movement of the dollar against not just one but several currencies.
The main authority that regulates the exchange in any country is the Central Bank, the key task of which is to maintain the value of the national currency at a level that is most suitable for the economy’s current state. The Federal Reserve System (FRS) is in charge of this in the United States.
To this effect, the Central Bank uses two key tools: the interest rate and quantitative easing (QE). Intervention - both verbal and real - serves as the third tool, even though it’s not popular and is used in emergency circumstances only.
The interest rate, also known as the refinancing rate is the rate used by the Central Bank to grant loans to commercial banks. When the economy needs a boost, the Central Bank makes the national currency cheaper by reducing the refinancing rate. When the economy is on the rise, it may lead to overheating, meaning that the economy’s productive capacity fails to keep up with the growing demand. This, however, can be avoided by increasing the interest rate.
Following the 2008 crisis, the Federal Reserve System gradually reduced the federal funds target rate from 5.25% to 0.25%. The first increase thereof took place only in 2015. In early 2020, the refinancing rate in the United States is 1.75%.
This is the second tool designed to regulate the exchange rate. In layman’s terms, it means the Central Bank takes out its money-making machine and starts printing the money unbacked by anything. The launch of quantitative easing, also known as stimulus program results pushes the exchange rate down. In contrast, the decrease in the stimulus program or its overall termination leads to an increase in the exchange rates.
After following the 2008-2009 crisis, the U.S. Federal Reserve System conducted three rounds of quantitative easing: QE1, QE2, and QE3. However, the last one QE3 completed in 2014 led to a rise in the price of the dollar.
No quantitative easing is currently implemented in the U.S. That said, it’s important to be aware of its impact. E.g. the current president of the United States Donald Trump has repeatedly criticized the Federal Reserve System, saying that the Central Bank should launch QE. However, the regulator’s response to this remains unchanged, - there is no need to do so now, but it will put the money-making machine to use when necessary.
For instance, the quantitative easing program is actively used in the eurozone in order to save the economy from recession. This explains why the Euro is plummeting against the U.S, dollar i.e. the price of dollar goes up against the euro.
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Another factor that affects the value of the dollar is supply-and-demand balance. The higher the demand for the U.S. dollar, the more expensive it gets, and vice versa - the lower the demand and the higher the supply, the cheaper the U.S. currency.
Keep in mind that we are not talking just about individuals and small traders, but also big market players, among which are the central banks of other countries that use U.S. dollars to form their foreign exchange reserves, commercial banks, large funds, as well as exporters and importers who purchase foreign currency to carry on business in other countries.
And when it comes to expectations, the major factor here is the level of interest in the risk. Investors and traders know well that the riskier the asset, the higher the profit that one can make on it. By the same token, the safest assets are less profitable, yet there is a certain demand for them during turbulent times.
When things are going well and the future prospects look promising, big investors invest their money into high-yield assets. However, in the case of market uncertainty or danger, the market players prefer to purchase the so-called safe-haven assets. In early 2020, major turbulence in the market was caused by the outbreak of the coronavirus epidemic, and last year, the markets were shaken up by the US-China trade war.
Thanks to its high interest rate and reliability, the U.S. dollar is highly popular at the moment. This is why its rate keeps going up against the backdrop of growing concerns about coronavirus and its possible damage to the global economy.
To keep their money safe, big market players prefer using reliable, though not always high-yield strategies, Carry Trade being one of them. Essentially, what you do is borrow money cheaply from a country with a low-interest rate and invest it into the country that has a higher interest rate. Today, there are countries with zero (the eurozone) or even negative interest rates (Japan and Switzerland). The investor’s profit is basically the difference between high and low interest rates.
The U.S. dollar brings together a solid refinancing rate (1.75%) and reliability. This makes this currency so popular when using the carry trade trading strategy. And, as you know, the price goes up when demand increases.
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