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What Next for the USD?

One can easily spot the extreme response to the COVID-19 crisis by the Federal Reserve of the United States. While the money supply and institutional money market assets grew from 2005 to 2020, the growth rate accelerated dramatically as a result of the pandemic. 

Inevitably, such a chart like the one below questions the very definition of a currency’s strength or value. Increasing the money supply leads to a decline in value, as 101 economics will tell us. However, not only that the USD did not decline in value all these years – it effectively got stronger.

How is that even possible? The answer comes from the exorbitant privilege of owning the world’s reserve currency. Because of that, demand for dollars far outpaces the issuance from the Treasury or the pace that the Fed creates digital dollars via the quantitative easing program.

Who Lends to the USA?

Indeed, the 101 economics concept stands true for every government or central bank that increases the money supply to debase the currency. Because there is no other demand side on the equation, the currency will eventually start losing its value.

In the case of the United States, things differ because of the reserve currency status. Other currencies are also used as reserves, like the EUR or the JPY, but not to the extent that the USD is.

Who lends the USA money? It is one thing to issue debt like the Treasury does, and another one to find buyers for that debt. These buyers are well aware of the chart above – yet they do believe that the dollar will keep its value over time so that they still bid for the dollar-denominated debt issued by the U.S. Treasury.

China and Japan buy over 33% of the U.S. debt. These two countries alone are responsible for financing one-third of the money the United States needs to fund its deficit. Other countries each contribute with a small share. For example, the United Kingdom buys 4.7%, Brazil 4.8%, or Luxembourg 3.5%.

We will not list all the countries because the list is awfully long. The point here is that one can issue more dollars, as seen in the increase in the M2 and institutional money market assets, without the USD’s value to decline. The explanation is quite simple – by issuing new debt and finding buyers for it, other countries in the world are willing to buy it, overcoming the USD supply with strong demand.

If the demand is stronger than supply, the USD will appreciate. As it did all these years – just remember the EURUSD traded at 1.60 or GBPUSD close to 2 only a decade or so ago.

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