Under the Bretton Woods agreement, currencies were pegged to the price of gold, and the U.S. dollar was the reserve currency linked to the price of gold. Following the collapse of the Bretton Woods agreement in 1971, the USD started to free-float against other currencies in the world. Since then, the USD became the pillar of the world’s financial system.
For the first time, the international currency market presented a huge opportunity to speculators and investors alike. Suddenly, investors with technical and fundamental background could turn from “regional” trading in the United States market to macro-trading.
Trading currencies mostly meant understanding the difference between the fundamentals of each economy and acting on the potential monetary policy divergences. Those were the early years of the foreign exchange market; very different from how it is today.
Fast forward almost fifty years and the trading arena has vastly changed. Nowadays, investors armed with personal computers, smartphones, dedicated software, and stable internet connections, can access the most significant financial markets in the world by a simple click on their trading platform. Whether in front of a desktop or a smartphone, investors actively buy and sell on the interbank market.
Yet, one thing remains the same: the role of the USD in the financial system and the overall currency market.
USD as the Pillar of Today’s International Trade
A currency is said to reflect the strength of an economy. Judging by this simple measurement, the USD is the most potent currency, as the United States is the world’s largest economy. This, of course, only works if we consider capitalist economies and free-floating currencies. The value of a free-floating currency is set by market forces, not the central banks. China is a strong economy that doesn’t allow its currency to free-float. Therefore, the rule regarding a currency’s strength depending on the size of the economy only works for capitalist economies.
There are many essential currencies whose strength depends on their economies: United Kingdom (GBP – Great British Pound), Eurozone (Euro – the common currency for 19 European economies, the largest being France & Germany), Japan (JPY – Japanese Yen), Canada (CAD – Canadian Dollar), Switzerland (CHF – Swiss Franc), Australia (AUD – Australian Dollar), etc. If we add up the economic output or, the Gross Domestic Product, of all the above economies (the total value of all goods and services produced by their economy) we would end up with a big chunk of the world’s GDP.
Coupled with the USD, those currencies represent the bulk of the forex dashboard. Their liquidity is reflected in the volume traded. International trade between these countries/regions accounts for trillions of dollars. Note the currency: American dollars.
Over eighty percent of international trade takes place in US dollars, making it indispensable to today’s financial system. Commodities, like oil and gold, both trade in USD. Foreign nations choose to keep around eighty percent of their excess reserves in USD, further increasing the need for USD around the world. If you add the fact that international loans take place mostly in dollars (or SDR ‘Special Drawing Rights’ in the case of an IMF ‘International Monetary Fund’ loan), then the inherent importance of the USD is clear.
Hence, when trading financial markets – currency market included – first monitor what is happening with the USD, before focusing on other areas. Chances are, investors will be better off if they monitor the behavior of the USD closely.
- Most international trade takes place in USD.
- Capitalist economies are responsible for a big chunk of international trade.
- Commodities trade in USD.
- Monitor the fundamentals of the US economy to understand where the USD goes next.