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When it comes to the decision of whether you should buy or sell dollars, it all boils down to how the economy is performing. A strong economy will attract investment from all over the world due to the perceived safety and the ability to achieve an acceptable rate of return on investment. Investors always seek out the highest yield that is predictable or "safe." Investment from abroad creates a strong capital account and a resulting high demand for dollars.

On the other hand, American consumption that results in the importing of goods and services from other countries causes dollars to flow out of the country. If our imports are greater than our exports, we will have a deficit in our current account. With a strong economy, a country can attract foreign capital to offset the trade deficit. The U.S. can continue as the consumption engine that fuels all the world economies even though it's a debtor nation that borrows this money to consume. This also allows other countries to export to the U.S. and keep their economies growing. This explanation is simplistic, but it illustrates a point. The point is that when it comes to taking a position in the dollar, the currency trader needs to assess the different factors that affect the value of the dollar to try to determine a direction or trend. (Learn more in Understanding The Current Account In The Balance Of Payments.)

Factors Affecting Dollar Value

The methodology can be divided into three groups as follows:

  • Supply and demand factors
  • Sentiment and market psychology
  • Technical factors

We'll take a look at each group individually and then see how they work together as a whole.

Supply Versus Demand for Dollars

When we export products or services, we create a demand for dollars because our customers need to pay for our goods and services in dollars. Therefore they will have to convert their local currency into dollars, so they sell their currency to buy dollars so that they can make the payment. In addition, when the U.S. government or large American corporations issue bonds to raise capital, and if these bonds are bought by foreigners then again the bonds have to be paid for in dollars and the customer will have to sell their local currency to buy dollars so they can effect payment. Also, if there is strong growth in the U.S. and companies are expanding their earnings then the desire by foreigners to own corporate stocks in the U.S. also requires that they sell their currency to buy dollars to pay for the purchase of stocks.

These situations create more demand for dollars, and that in turn puts pressure on the supply of dollars, increasing the value of the dollar relative to the currencies being sold to buy dollars. On top of this, the U.S. dollar acts as a safe haven during times of economic uncertainty, so demand for dollars can often persist despite the performance of the U.S. economy.

Sentiment and Market Psychology

But what if the U.S. economy weakens and consumption slows due to increasing unemployment? Then the U.S. is confronted with the possibility that foreigners may sell their bonds or stocks and return the cash from the sale in order to return to their local currency. Hence they sell the dollars and buy back their local currency. This type of activity has a dampening effect on the dollar.

Technical Factors That Impact the Dollar

As traders, we have to gauge whether the supply of dollars will be greater or less than the demand for dollars. To help us determine this, we need to pay attention to various news and event items. This includes the release by the government of various statistics, such as payroll data, GDP data and other economic information that can help us to determine what is happening in the economy and to estimate whether the economy is strengthening or weakening. (For a comprehensive overview of 24 major indicators, take a look at our Economic Indicators Tutorial.)

In addition, we need to determine the general sentiment regarding what the players in the market think the outcome of events is likely to be. Very often, sentiment will drive the market rather than the fundamentals of supply and demand. To add to this mix of prognostication, we also have the historical patterns generated by seasonal factors, support and resistance levels, technical indicators and so on. Many traders believe that these patterns are repetitive and therefore can be used to predict future movements. (Learn about the basics of technical analysis in our Technical Analysis Tutorial.)

Bringing Them All Together

Since trading relies on the ability of a trader to take a risk and manage it accordingly, traders usually adopt some combination of the three above methods to make their buy or sell decisions. The art of trading exists in stacking the odds in your favor and building an edge. If the probability of being correct is high enough, the trader will enter the market and manage his hypothesis accordingly. To stack the odds in our favor we therefore need to take into account each one of the three methodologies and hopefully find them to be congruent, meaning that they all point in the same direction.

An Example of a Dollar Shift

The economic conditions during the recession that began in 2007 forced the U.S. government to play an unprecedented role in the economy. Since economic growth was receding as a result of the large deleveraging of financial assets taking place, the government had to take up the slack by increasing government spending to keep the economy going. The purpose of their spending was to create jobs so that the consumer could earn money and increase consumption thereby fueling the growth needed to support economic growth. (For a review of the recession during this time period, refer to The 2007-08 Financial Crisis In Review.)

The government took this position at the expense of an increasing deficit and national debt. It financed this increase by essentially printing money and by selling government bonds to foreign governments and investors - resulting in an increase in the supply of dollars. The dollar depreciated as a result.

The Bottom Line

It may be helpful for a trader to keep an eye on the Dollar Index chart to provide an overview of how the dollar fares against the other currencies in the index. By watching the patterns on the chart and listening to the sentiment in the market, as well as monitoring the major fundamental factors that affect supply and demand, a trader can develop a big picture sense of the flow of dollars and develop an insight to choose profitable positions in future trades.

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