With the brouhaha in Washington continuing to dominate both the financial and main stream media, and the deadline for a technical US default drawing ever nearer, in fact the deadline is 17th October, regardless of what actually happens on the 17th, one thing is certain. We will begin to hear once again questions about the role of the US dollar as the currency of first reserve as well as its importance in global trade.
I have to confess that when I first started trading I was unaware of the role the US dollar plays in world markets. Like many, I naively assumed that all currencies were equal, and in my case my only contact with foreign exchange was when I needed to convert British Pounds into Italian Lira for my trips back to see my relatives. This was always a satisfying experience as in those days one British Pound equalled 2000 lira (and sometimes even more) which meant that for a few hundred pounds I could be a Lira millionaire.
Now, of course, I am acutely aware of the impact and importance of the US dollar on both my trading and in my daily life. The latter because all commodities are priced in dollars and it is the relative strength or weakness of the US dollar which ultimately determines the cost of food and energy. This, in turn has a direct impact on inflation and what we eventually pay for the bread we eat and the energy we use.
The correlation between commodities and the US dollar is fairly straightforward – a weak dollar leads to higher commodity prices, while a strong dollar results in lower commodity prices. However, there are a couple of other facets to this relationship. The first is that commodities have had a huge boost from the FED’s QE program which has inflated, and is continuing to artificially inflate many asset classes, including commodities. In other words by creating more dollars and lowering its value the FED is not only perpetuating this general correlation but these additional dollars are also bidding up commodity prices because commodities are now an asset class in their own right & attracting money looking for a return.
Of course, the exception, at the moment, is the relationship between gold the US dollar, and here the picture is very different.
For a number of months now the gold price has been falling along with the US dollar, causing many traders and investors to scratch their heads in bewilderment. Many reasons have been suggested from market manipulation, to a fall off in demand from India as a result of increased import duty and the RBI – The Reserve Bank of India – instructing rural regional banks they can no longer provide loans against gold coins and jewelry. The Bank has also ruled out any credit transaction for gold imports, unless they are intended to make jewelry for export.
This may indeed be the case but ironically the Indian Rupee has recently strengthened against the US dollar by almost 15% since mid September, thereby offering traders and investors excellent buying opportunities (Indian government permitting!)
The gold dollar relationship also takes centre stage at times of financial stress, and no more so than back in late 2008 when the world was on the brink of a financial catastrophe. Here money flow was into both gold and the US dollar, as traders and investors sought out the safe havens. This pattern was repeated again in 2010 at the height of the crisis in the Eurozone when debt problems in those countries affectionately known as the PIGS – i.e. Portugal, Ireland, Italy Greece and Spain threatened the stability of global financial system.
However, returning to the US dollar and to its position as the world reserve currency, a position which the former French president Valery Giscard d’Estaing referred to as ‘exorbitant privilege’. And here we are seeing clear signs of a backlash – not least from the Chinese who are the holders of more than $3 trillion of dollar foreign exchange reserves, $1.3 trillion of which are held in US Treasuries. For many Chinese it has apparently come as a revelation that to discover they own so much US debt. Could this be one reason why the Chinese are now the principal buyers of gold? It would make sense.
China’s official government new agency recently said : ‘It is perhaps a good time for the befuddled world to start considering building a “de-Americanised world”. However, despite what is going on in Washington, and even the threat of a technical default by the US in the short term US dollar dominance will continue and the reason is simply it has no serious contender.
The figures are staggering: it is estimated that more than 60% of global foreign exchange reserves are held in US dollars. Second, that the US dollar now accounts for over 80% of global forex trading, providing a depth of liquidity which no other currency can match.
Dollar liquidity provides the bridge for many forex exchanges and transactions. An example I came across recently, explained how a sell of the Singapore Dollar to buy the South African Rand is carried out by first converting the SGD (Singapore dollar) to US dollars and then using these to buy the Rand. We could say the dollar is the jam in the sandwich.
In my book A Three Dimensional Approach to Forex Trading I explain in more detail why the forex market is not a linear, one dimensional market, simply because an individual currency can be bought and sold against a myriad of others, thereby creating a cats cradle of multi level relationships. Unlike trading and investing in gold, silver or a stock the buying and selling of currencies is not straightforward.
So what is a humble trader and investor to do? And the answer is actually very simple – and that is to ensure that whatever market or instrument you are trading – you must have a view on the US dollar from both a fundamental and technical perspective.
The technical picture for the US dollar can now be found on three different charts. The first is the DXY and is sometimes referred to as the DIXIE.
At the moment this index is trading at 80.36 having been in a downtrend since early September. For the past few days the index has, not surprisingly, been consolidating in the wake of the problems in Washington, waiting like everyone else for some resolution to the debt ceiling crisis.
There are two other dollar indices available. One is a futures contract quoted on the CME exchange and which is based against a basket of ten currency futures, with the ticker FXD. You can find details and charts at the exchange. The other, is one developed by FXCM in association with the Dow Jones Corporation.
It is the second of these I like to use in my own forex trading for the simple reason that the basket of currencies which comprise the index are equally weighted and far more representative of the forex market.
Unlike the DXY which includes the Swedish Krona, but no Australian dollar and a massive weighting for the Euro, the Dow Jones FXCM dollar index is composed of four currencies, all equally weighted at 25%. These are the euro, the british pound, the Australian dollar and the yen. The technical picture here too is similar to the DXY, but has a more bearish tone than the DXY.
In summary – whether we like it or not the US dollar is still the king pin of the global financial system, and will continue to be so, until a viable alternative emerges or is created. But until that day – please ensure you keep a close watch on the US dollar as it really impact every trading and investing decision, in every time frame.
By Anna Coulling