Over the past year, the U.S. dollar, as measured by the Dollar Index Spot rate according to Bloomberg, has remained flat at around an index level of 80. The index spent most of early 2012 submerged below 80, but perked up to nearly 84 in July, before settling back at just below 80 to end the year. It recently traded at 80.336, which represents a modest one-year decline of 1.1% .
Comparing the Dollar
The above index provides an indication of how the U.S. dollar trades. Another, perhaps more conventional approach is to compare the dollar to other foreign currencies. Foreign exchange or currency traders make decisions based off their expectations for the dollar and how it will trade in relation to the currencies of other countries. Common currency pairs include the dollar with the Japanese yen, European euro, Canadian dollar, as well as the Swiss franc and British pound.
Traders look to make educated bets on currencies by looking at the economic factors of an underlying issue. At this point, currency trading grows incredibly complex, with a wide array of factors that may or may not impact the level of a currency, such as the U.S. dollar, or how it trades against competing currencies. Winston Churchill once described how Russia operates as "a riddle wrapped in a mystery inside an enigma" to illustrate that it was extremely difficult to say for certain what motivated it to run its national interests. This also applies to the factors that influence the U.S. dollar and currencies in general.
The U.S. Dollar's Stability
As Churchill did with Russia, currency traders try to key in on the most important drivers of the U.S. dollar. A primary factor is certainly the relationship between supply and demand for dollars. Despite a tenuous government fiscal position and a hit to its reputation courtesy of the financial crisis that included a downgrade of America's credit rating, the U.S. dollar is still seen as one of the safest stores of value in the world, which helps it hold its value. Other countries, including the Hong Kong region of China and Panama, peg their currencies directly to the dollar. Recent estimates show that more than 60 countries have direct currency pegs to the mighty greenback. Another primary factor is sentiment on the dollar, which includes emotional financial markets that trade based off of fear and exuberance, and also shorter-term technical factors that affect nearly every financial asset.
To return again to Churchill's enigma reference, a popular foreign exchange website comprehensively listed 50 factors that help influence the value of the U.S. dollar. Major categories included politics, such as budget deficit and national debt levels, which are important areas of concern these days. The political environment in other countries also plays a role in how the dollar trades compared to other currencies, as referenced above. Entitlement programs such as Social Security and Medicare are important considerations, as an aging population in America will affect how likely the government will be able to cover its obligations in the future.
U.S. Government Policy
Economic theory, returning to the demand for dollars and variability in the money supply, both in the U.S. and internationally, is another key category. The level of U.S. interest rates is very important, especially in comparison to other countries, where traders can invest and potentially earn higher returns on debt. A popular strategy among foreign exchange traders is to borrow in a currency with a low interest rate and use those proceeds to invest in a currency with a higher comparative rate. Other industry and economic indicators, such as unemployment rates and industrial production, also serve as an indicator on how strong a country's economy is, which impacts its currency level.
The Bottom Line
An Economist article, following the credit crisis cited Alan Greenspan, the former Chairman of the Federal Reserve, as stating that "The United States can pay any debt it has because we can always print money to do that." For this reason, the underlying U.S. dollar remains the most popular and safest currency in the world. As long as the U.S. economy and related factors that affect the government support the payment of national debts and expenses remain sound, this should continue. Currency traders and other currency investors will continue to monitor the variety of factors that affect the dollar closely for signs that they can profit from, how it trades overall, and how it performs in comparison to other foreign currencies.