The dollar is the world’s reserve currency, a role it took in 1944 after the Brent Wood Agreement. Since then, this role has helped cement the United States as the world super power. The country has flexed its muscle in many conflicts around the world. It has imposed sanctions on leaders who violate its policies. It has also imposed sanctions on countries like Venezuela, Russia, and North Korea.
By imposing sanctions, the US is able to impose its policies in all countries around the world. This is because all banks are required to use the dollar in one way or another. If a bank can’t access the dollar, it is unlikely to be involved in international transactions.
This year, the dollar has performed very well against other currencies. The dollar index has risen by more than 4% this year. The implications of this have been severe. Since most commodities are quoted in dollars, the strong dollar has led to their price declines. Since most of these commodities come from the emerging markets, the decline in their prices have affected their economies. Countries like South Africa, Turkey, and Argentina that borrowed heavily in dollars have been hurt. The same is true with the developing countries.
The stronger dollar has also helped save the economies of key exporting countries in the European Union, China, and Japan. As the dollar declines, the products of these countries become cheaper for the world markets.
The strength of the dollar has been caused mostly by the US monetary policy. The Fed has been the most aggressive central bank in the developed world. Already, it has made two rate increases and is scheduled to have another hike in September. In the recent Fed minutes, the officials left the chance open for another rate hike in December this year.
As the rates increases, the yield of the dollar increases. This leads to more demand for the better-yielding currency. It is also a sign of the confidence of the economy.
There are concerns that the rally on the dollar might be coming to an end. This is because the Fed is unlikely to have more rate hikes in the coming year. More rate hikes could invert the yield curve, which is a situation the Fed does not want to happen. An inverted yield curve could lead to a recession.
On the other hand, other central banks are likely to start hiking in the coming year. Already, the ECB has shown signs that it will increase in September, Bank of England has signalled its willingness to hike, while the bank of Japan is likely to hike or show hawkish signs. Therefore, since traders price in rate hikes, it is likely that the other currencies will rise against the dollar.