Understand the why and how USD dominates world financial markets, and the emerging trends from shifts in geopolitics and global trade.
The US dollar's global financial dominance stems from its historical roles, the strong American economy, and deep, liquid financial markets. It serves as the primary reserve currency, a safe haven, and the main medium for international transactions, offering the US benefits like lower borrowing costs and geopolitical influence.
However, challenges are emerging. China's economic rise and other emerging markets threaten the dollar's supremacy.
This article will examine the dollar's enduring history, its role in global trade and challenges. Understanding these dynamics is crucial for understanding the global forex market, which is largely dominated by the US dollar.
Brief history of the US dollar
The U.S. dollar became the world's leading reserve currency due to America's economic strength and political stability. Its origins trace back to the 1792 Coinage Act and the 1913 creation of the Federal Reserve.
The 1944 Bretton Woods Agreement definitively cemented its global role, pegging other currencies to the dollar, which was convertible to gold. Even after Bretton Woods collapsed in 1971, the dollar maintained its dominance due to the size and liquidity of U.S. financial markets, the depth of the U.S. economy, the perceived safety of U.S. Treasuries, and its widespread use in international trade, particularly for oil.
Despite facing challenges and fluctuations over time, the dollar has maintained its dominant position in global finance as a key reserve and transaction currency.
The US dollar's role as a reserve currency
Central banks and financial institutions hold a lot of reserve currencies as part of their foreign exchange reserves. Reserve currencies are like global benchmarks for trade and are used for international transactions and investments. The best reserve currencies are usually stable, liquid, and backed by big, reliable economies.
According to the IMF, the US dollar pretty much nails these criteria, making up about 57.8% of global foreign exchange reserves as of 2024. The euro comes in second at 19.8%, then the Japanese yen at 5.82%, the British pound at 4.73%, and the Chinese yuan, which is definitely on the rise, at 2.18%.
The US dollar in world trade
- International trade and finance: The dollar underpins trade and finance infrastructure worldwide. International contracts, loans, and commodities are mainly denominated in the dollar. Moreover, US-based financial systems such as SWIFT and CHIPS are central to international banking.
- International demand for US bonds: US Treasuries are regarded as a safe-haven, offering global investors a dependable and highly liquid market in which to store their assets.
- Main currency in global energy trade: The global demand for the US dollar has been strengthened since the 1970s due to its dominant role in pricing and conducting most international oil transactions among energy-importing nations.
- Economy size: The U.S. boasts the world's largest economy with extensive financial markets.
Challenges to the US dollar
- BRICS efforts to de-dollarise: Several nations, including Russia, Iran, Brazil, and India, collectively known as the BRICS nations, are actively working to lessen their dependence on the US dollar for trade. This move towards "de-dollarisation" is often driven by geopolitical considerations or concerns about potential US sanctions.
- Rise of Chinese yuan: Related to the BRICS efforts to de-dollarise, the ongoing internationalisation of the Chinese yuan (renminbi) is a strategic, long-term effort to lessen reliance on the dollar. Key initiatives supporting this goal include the Belt and Road Initiative and the establishment of the Cross-Border Interbank Payment System (CIPS).
The US dollar in financial markets
- Forex: The US Dollar functions as a global currency in international trade and financial transactions. It is the primary reserve currency for central banks worldwide and is the most traded currency in the FX market.
- Gold: A negative correlation typically exists between the U.S. dollar and the gold market. An increase in the dollar's value often coincides with a decrease in gold prices; conversely, a decrease in the dollar's value often leads to an increase in gold prices.
- Bonds: Bonds are considered secure, low-risk assets, generally moving in tandem with the US dollar. A rise in 10-year US Treasury note yields typically strengthens the dollar. In uncertain economic times, investors gravitate towards safer bonds from riskier assets like stocks, boosting the dollar's value.
Closing
For now, the USD is still the most traded worldwide and has high liquidity, it is considered a safe-haven currency with both JPY and CHF. Traders worldwide watch the US dollar closely as it affects the world’s forex markets.
Tracking dollar changes in global markets is best accomplished using the DXY. The index offers an understanding of market trends, risk attitude, and the relative value of the most traded currencies worldwide. In a practical trading set-up. The Currency Strength Tool offered on the OANDA Labs website comes in handy, enabling traders to track currency strengths.
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