Traders need to pay attention to the difference between expectations and actual values of economic indicators. This is the most crucial part of interpreting news because it influences the foreign exchange market depending on market expectations and actual values.
This is called a market discount mechanism, showing the relationship between the forex market and the news are significant. If the information or economic indicators are closer to expectations, there is less impact on monetary movement. Therefore, short-term traders should look carefully at market expectations.
The Overview of US Dollar (USD)
The U.S. is the world’s leading and largest economy. Based on the purchasing power evaluation model, it is three times the production of Japan, five times the output of Germany, and seven times the production of Britain. The United States is a service-oriented country where real estate, transportation, finance, medical services, and business services account for about 80% of GDP.
Foreign investors have continued to increase their purchases of U.S. assets because the U.S. has the world’s most liquid stock and bond markets. According to the International Monetary Fund (IMF), the number of foreigners directly investing in the United States amounts to 40 per cent of the world’s funds flowing into the United States. The United States also absorbs 71 per cent of all overseas savings.
This means that if foreign investors withdraw their funds in the U.S. asset market, the asset value and the U.S. dollar will be significantly affected. More specifically, if foreign investors dispose of dollar-denominated assets to purchase other high-yield investments, this would result in a decline in the value of U.S. assets as well as U.S. dollars.
The size of U.S. imports and exports also exceeds that of other countries. This is due to the size of the United States itself, and the actual size of U.S. imports and exports is only 12% of GDP. Despite this massive trade activity, the United States recorded a current account deficit. This is a problem that the U.S. economy has been troubled with for more than a decade.
And over the last decade, the U.S. has weakened its overseas funding capacity as foreign central banks have considered diversifying their reserve assets from the dollar to the euro, making the current account deficit a bigger problem. The U.S. dollar is susceptible to changes in capital flows due to its massive current account deficit.
The United States is also the largest trading partner in many countries, with U.S. trade accounting for 20 per cent of the world’s trade. The changes in dollar-value and volatility affect trade activities with U.S. trading partners. More specifically, a weak dollar will boost exports of U.S. products, but a strong dollar will reduce overseas demand for U.S. products.
FED Regulate Monetary Policy
The Federal Reserve is a U.S. monetary policy authority. The FED determines and implements monetary policy through the FOMC. The FOMC’s voting members are seven members of the FED and five of the 12 regional Federal Reserve governors. The FOMC holds regular meetings eight times a year, widely watched as it decides whether to adjust interest rates or presents economic growth forecasts.
The FED has an entirely independent monetary policy authority and less political influence. This is because most board members can serve a very long term (14 years), even if the ruling party of the president and Congress changes.
The FED will issue monetary policy reports for the first half of February and July, followed by Humphrey-Hawkins testimony. The Federal Reserve Chairman answers questions from Congress and the Banking Committee regarding the report. It is worth noting that the report includes the FOMC’s outlook on GDP, inflation and unemployment.
Unlike other central banks, the FED has the authority to achieve its long-term goal of price stability and sustainable economic growth. To achieve this goal, the FED must control inflation and unemployment and implement monetary policies for balanced growth. The most common means used by FEDs to control monetary policy are open market manipulation and federal funding rates.
1. Open Market Manipulation
Open market manipulation involves FED buying state bonds, including treasury bills, treasury notes, and treasury bonds. This is one of the most common means of FED to suggest and implement policy changes.
In general, if FED increases the purchase of state bonds, liquidity is supplied to the market, which lowers interest rates. When FED sells state bonds, it absorbs market liquidity and increases interest rates.
2. Federal Funding Goals
The federal funding target rate is a key policy objective of the Federal Reserve and refers to the interest rate that the FED applies to loans to member banks. FED drive growth and consumption by raising federal funds rates to lower inflation or lower federal funds rates. Changes in federal funding rates are closely observed in the marketplace, meaning significant policy changes, which have a broad impact on bond and stock markets worldwide. The market pays particular attention to the fed statement, as it provides clues to the future direction of monetary policy.
In terms of fiscal policy, the U.S. Treasury Department has the right to determine the federal funds rate. Determination of fiscal policy involves determining appropriate levels of tax and government expenditure. The market is paying more attention to the FED, but the real government agency that determines the dollar policy is the U.S. Treasury Department.
In other words, if the dollar is judged to be undervalued or overvalued in the foreign exchange market, the Treasury Department grants or directs the New York Federal Reserve to sell or buy U.S. dollars by allowing it to intervene in the foreign exchange market. Therefore, changes in the Treasury’s dollar policy and its policies are critical to the currency market.
Key Characteristics of the Dollar
1. More than 90% of all currency transactions are dollar related.
The most volatile currencies in the foreign exchange market are EUR/USD, USD/JPY, GBP/USD and USD/CHF. These currencies are the most actively traded globally and are related to the U.S. dollar. More than 90% of all currency transactions are related to the U.S. dollar, so the dollar is significant for foreign exchange traders. Therefore, the most important economic indicator that drives the market is the fundamentals of the United States.
Before the September 11 attacks, the dollar was the world’s best safe currency.
The U.S. dollar was considered the world’s highest safe currency because the U.S. stability was very high before September 11, 2001. The United States was known as one of the safest and most advanced markets in the world. The dollar’s status as a safe asset allowed the United States to attract investment at a low rate of return, and 76% of the world’s monetary reserves were dollar-denominated assets.
Another reason for holding monetary reserves in U.S. dollars is that the dollar is the world’s key currency. The dollar’s position as a safe asset has played an essential role in choosing a reserve currency for foreign central banks. However, foreigners, including central banks, have had less U.S. assets since September 11, as uncertainties about the U.S. increased and interest rates have fallen.
The emergence of the euro also threatened the dollar’s status as the world’s top reserve currency. Many of the world’s central banks have already begun to diversify their reserve currencies by reducing their dollar reserves and increasing their euro reserves. This trend is an essential thing for all traders to watch in the future.
2. The U.S. dollar moves in the opposite direction to the price of gold.
Historically, the gold prices and the U.S. dollar shows conflicting mirror images. This means that the dollar falls when gold prices rise and vice versa. This inverse correlation stems from the fact that the value of gold is measured in dollars.
Gold has long been recognized as the ultimate form of currency, so the depreciation of the dollar due to global uncertainty has been the main reason for the rise in gold prices. Also, because gold is considered the best safe asset, investors will flock to gold if it highlighted geopolitical uncertainty. This inherently undermines the value of the dollar.
3. Many emerging countries link their currency values to the dollar.
Interlocking the dollar has to do with the basic idea that the government will agree to keep the U.S. dollar as a reserve currency by buying or selling its currency at a fixed exchange rate for the reserve currency. These governments should promise to have at least the same amount of national currency and reserve currency in general circulation.
Therefore, these central banks, which have held large amounts of U.S. dollars and are actively interested in managing fixed or variable exchange rates, are critical. Currently, Hong Kong has a fixed exchange rate system linked to the dollar, and China has also maintained a fixed exchange rate system linked to the dollar until July 2005.
China is a very active participant in the currency market. This is because China’s maximum daily fluctuation is controlled within a very narrow range based on the closing exchange rate of the U.S. dollar the previous day. If it goes beyond this within a day, the central bank will buy or sell dollars through foreign exchange market intervention.
Before July 21, 2005, China implemented a peg system that fixed its exchange rate at 8.3 yuan to the dollar. Under pressure to appreciate the currency for many years, China adjusted its currency rate to 8.11 yuan and adjusted it to the closing price of the currency every day. Since then, China has shifted to a management-varying exchange rate system based on the currency basket exchange rate.
Over the past one or two years, the market has noted the asset acquisition patterns of these central banks. The need for U.S. dollars and dollar-denominated assets is gradually decreasing for central banks as the diversification of the reserve currency, and the flexibility of the exchange rate system in Asian countries progresses. If this is true, it could be a very negative factor for the U.S. dollar in the long run.
4. Interest rate differences between U.S. government bonds and overseas bonds are strongly followed.
The difference in interest rates between U.S. government bonds and overseas bonds is an essential relationship that professional FX traders follow. This could be a strong indicator of potential currency movements, as the U.S. bond market is one of the world’s largest bond markets, and investors are very sensitive to the return of unsold assets.
Large investors are always looking for assets that offer high returns. Investors will sell U.S. assets and buy overseas assets if the yield on U.S. bonds decreases or increases foreign bonds. Selling U.S. bonds or stocks will affect the currency market, as it involves selling U.S. dollars and buying foreign currencies. If the yield on U.S. bonds increases or the yield on overseas bonds decreases, investors will eventually buy U.S. assets, resulting in a strong U.S. dollar.
5. Keep an eye on the dollar index.
Market participants closely observe the US DOLLAR INDEX (USDX) to measure overall dollar strength or weakness. USDX is a futures contract traded on the New York Exchange, which is determined by the weight of trade volume in six major countries worldwide.
It is essential to share the index because market participants refer to the general index when discussing a general weakening of the dollar or a fall in the trade-weighted dollar. Besides, even if the dollar fluctuates significantly against individual currencies, USDX may not move significantly because it is based on trade weights.
The index is important because some central banks focus on the trade price index rather than the individual currency pair movement against the dollar.
6. The U.S. Dollar is affected by the stock market and bond market
There is a strong correlation between a country’s stock and bond markets and its currency. In general, a rise in the stock market will bring in foreign funds to gain investment opportunities. If the stock market falls, local investors will sell local stocks to seize overseas investment opportunities.
For the bond market, a more robust economy would prompt the inflow of foreign capital. Changes in exchange rates and developments in these markets result in changes in foreign portfolio investment, requiring foreign exchange transactions.
M&As between countries are also an essential part of FX traders’ watch. Large-scale M&A involving significant cash transactions have a substantial impact on the currency market. Because the buyer must buy or sell dollars to secure cross-border mergers and acquisitions funds.
Important U.S. Economic Indicators
The following economic indicators are all critical indicators for the U.S. dollar. Since the U.S. economy is a service-oriented country, the service sector’s indicators should be taken into account.
1. Employment-Non-Farm
U.S. employment indicators are the most important and highly watched economic indicators. This is due to the Federal Reserve’s political influence under intense pressure to control unemployment. As a result, interest rate policies are directly affected by employment conditions.
It includes two surveys: a monthly reporting business survey and a household survey. Business survey results in non-agricultural employment, average weekly working hours per hour, total working hours index, and household survey results in information about the working population, household employment, and unemployment rate.
Forex traders watch for significant changes in the monthly unemployment rate and the number of non-agricultural workers who have undergone a seasonally adjusted period.
2. Consumer Price Index
The Consumer Price Index (CPI) is a crucial measure of inflation and the price of a basket of consumer goods. Economists focus more on source inflation, except for CPI-Utility or highly volatile foodstuffs and energy items. The consumer price index is observed with interest in the foreign exchange market because it can lead to various economic and social changes.
3. Producer Price Index
The PPI is an index that measures the average change in sales prices released by domestic producers. The PPI tracks price changes in almost all production industries in the country like agriculture, electricity, natural gas, forestry, fishing, manufacturing, and mining. The foreign exchange market traders should watch how the PPI index reacts monthly, quarterly, and annually along with the seasonally adjusted PPI.
4. Gross Domestic Product
Gross domestic product (GDP) is a measure of the total amount of goods and services produced and consumed in the United States. The Bureau of Economic Analysis (BEA) comprises two complementary components: income-based data and expenditure-based data.
The reserve of GDP released a month after the end of each minute is the most important indicator that includes estimates of inventories and trade balances that have not yet been disclosed. Other announcements of GDP are not necessary unless they are significantly revised.
5. Trade Balance
The balance of trade represents the difference between imports and exports of goods and services. It provides detailed information on trade with all countries and individual goods and trade with specific countries and regions. Traders judge the monthly benchmark figure to be low in reliability and focus on the three-month seasonally adjusted trade balance.
6. Employment Cost Index
The ECI is a measure of employees’ remuneration at the end of each quarter’s third monthly pay cycle. The survey measures the probability of approximately 3,600 private company employees and 700 state and local governments, public schools, and public hospitals.
A significant advantage of the Employment Cost Index is that it includes non-wage expenses that account for more than 30% of the total employment cost. It is necessary to pay close attention because it is an indicator that the Fed is watching.
7. Institute for Supply Management
The ISM publishes monthly composite indices calculated by surveys from 20 industries and 300 manufacturers nationwide. An index greater than 50 indicates an expansion of the competition or a contraction for less than 50. It is widely seen as one indicator that Alan Greenspan, former chairman of the Fed, watched very closely.
8. Industrial Production Index
The Industrial Production Index is an index that measures the performance of U.S. manufacturing, mining, and utility production. It is possible to identify production activities for each industry and item. The foreign exchange market mainly focuses on the total number of seasonal changes. An increase in the index usually causes a strong dollar.
9. Consumer Confidence Index
The Consumer Confidence Index is calculated based on consumers’ individual economic perceptions. The survey is based on a sample of 5,000 households nationwide, usually calculated with 3,500 responses. It’s a total of five questions.
– Local business conditions.
– Regional Economic Outlook in 6 Months.
– Employment situation in the region.
– Prospects for employment in 6 months.
– Forecast of household income in 6 months.
The survey responses shall be individually indexed after seasonal adjustment and then made into a composite index. Market participants perceive the rise in the consumer confidence index as a signal of increased consumer spending. Increasing consumer spending is often seen as a catalyst for accelerating inflation.
10. Retail Sales
The Retail Sales Index measures monthly gross sales by selecting a retailer sample. It represents a measure of consumer spending and consumer confidence. The index excluding car sales is the most important because of the large monthly fluctuations in automobile sales. Retail sales are very volatile due to seasonal factors, but they are an essential indicator of economic status.
11. Treasury Department International Capital Outflow Data (TIC Data)
The TIC data is a monthly measure of the total amount of capital inflows into the United States. The data has grown in importance over the years as the U.S. trade/financial deficit has deepened.
It becomes a more significant issue as a way to resolve the U.S. trade deficit, and the market pays attention to the capital flow of the public sector, which represents the demand for U.S. bonds by foreign central banks.