What’s Driving U.S. Dollar Trades Today?

The US Dollar is the world’s most liquid currency, but its fundamental roles shift depending on the needs and focus of the global market

A textbook treatment of the ‘Greenback’ tends to treat it as a global safe haven, but that is not always its principal role

The appeal of expected interest rates and the level of commodity prices can have a disproportionate influence on USD – all of which we have seen play out in 2022

Gaining an accurate fix on the prevailing driver of a currency’s market moves affords the astute investor an opportunity to realize anticipated returns. But make no mistake, there can be a great deal of frustration when it comes to employing fundamental analysis in our day-to-day investment analysis. That is particularly the case when sorting the market’s perspective on a macro scale. Yet, that is the starting point for all forex traders given the scale of representation for the fiat assets. Rather than throw in the towel on fundamentals and simply revert to chart reading, it is worth understanding the core use of the currencies which you intend to trade. Given the US Dollar represents approximately two-thirds of currency transactions around the world, it is a critical starting point to understanding the waters you are wading into with ‘FX’.

The dominant fundamental influences over currencies tend to fluctuate over time as the financial backdrop changes. That has certainly been the case with the Dollar through 2022 and even the month of March. There are three competing roles the US currency has played for the markets in just this past month alone. This has frustrated many traders, seeking to interpret how to play critical developments such as the FOMC’s first rate hike in years and bouts of extreme volatility in the stock market.

First and foremost, the Dollar is treated as a safe haven as it reflects the world’s largest economy, the largest government bond market and an extremely high sovereign credit rating (almost ‘triple A’ across the board except for Standard & Poor’s designation). In times of extreme duress, the Dollar does tend to rise as global investors looking for a haven of last resort tend to move more of their capital into extremely liquid pools like those found in the US. That said, in more conventional swings in global sentiment, the USD can be a relatively poor weathervane, plagued by the same liquidity that it benefits from in times of extreme sentiment (bullish and bearish). During the height of the late February volatility during the initial Russian invasion of Ukraine, we saw the currency’s haven priority kick in very explicitly.

A great pair to highlight the intensity level of the Dollar’s safe haven appeal is USDJPY (US Dollar – Japanese Yen exchange rate). The Japanese Yen is also known as a ‘safe haven’ currency among FX traders, so we pit two fundamental ambassadors against each other. As it happens, during most of the market’s typical ebb and flow between the moderate bands of ‘risk on’ and ‘risk off’, the Japanese currency tends to play the role of the haven. Why is that? While the Yen does act as a safe haven under normal market conditions, its position in that spectrum has more to do with Japanese investors. Over the past three decades, there has been little-to-no yield to be found in the country’s assets as benchmark rates have been essentially zero-bound owing to persistent deflation. That has created a need among the country’s investors to deploy their funds globally in order to earn a meaningful level of return on investment. The less concern there is over volatility – locally and globally – the more capital is deployed abroad. Conversely, if the landscape grows rocky, Japanese investors tend to bring their capital home which results in an appreciation of the local currency (eg a drop in USDJPY).

This relationship highlights another aspect of the Dollar and general method of evaluation for the FX market at large. Interest rates play a critical role in pulling global capital into different countries and thereby the currency’s they use. That has been a particularly important theme through 2022 thus far as the Federal Reserve announced its first-rate hike (25 basis points to a range of 0.25-0.50 percent) and issued forecasts for another 150 basis points worth of tightening through the rest of the year. That is an aggressive tempo for the US authority and for the developed world at large. As that forecast rises or retreats, the Dollar tends to track the perceived value. Of course, the FOMC isn’t the only bank at work. Everything in the currency markets is relative, so the relative yield forecast needs to be compared to the forecast of the UK, Eurozone, Canada, etc.

The third fundamental guise that we have seen the Dollar occupy in just the past month is related to the functional status of the currency itself. While there are a great many currencies across the globe, the USD is by-far the most heavily used of its peers. That in turn makes it a more appealing tool for transacting in assets that are the same regardless of what country you occupy – most notably commodities. A by-product of the Russian invasion of Ukraine was an exacerbation of commodity prices as already taxed supply chains were further troubled by the geopolitical fallout. For countries that have to import much of their raw materials for domestic consumption or production of finished goods, the higher cost of the commodities necessitates more dollars in order to purchase the goods.

With these different roles for the US Dollar highlighted, how do we go about determining what fundamental course the currency is most closely following so we can appropriately analyze the market and positions before us? Influence is typically a basic hierarchy of needs. What is more pressing at any given time: fear, the disparity in expected returns, or the cost of natural resources? So long as one of these drivers is more significant relative to its two counterparts, the currency is more likely to follow that given line. In the event that all three are low, the markets tend to operate on nuance; but the opposite does not hold. If all three of these factors are seeing extremes, fear tends to override, returning the Dollar to its ‘textbook’ safe haven role.