3 Factors That Drive the U.S. Dollar

The economy's performance is at the heart of the decision to buy or sell dollars. 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.

Since investors always seek out the highest yield that is predictable or "safe," an increase in investment, particularly 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. That allows the U.S. to continue its role as the consumption engine that fuels all of 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 own economies growing.

From a currency trading standpoint, when it comes to taking a position in the dollar, the trader needs to assess these different factors that affect the value of the dollar to try to determine a direction or trend.

Factors Affecting Dollar Value

The methodology of determining dollar value trades can be divided into three groups as follows:

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

Below we'll take a look at each group individually and then see how they work together as a unit.

1. Supply vs. Demand for Driving Dollar Value

When the U.S. exports products or services, it creates a demand for dollars because customers need to pay for goods and services in dollars. Therefore they will have to convert their local currency into dollars by selling their own currency to buy dollars to make the payment.

In addition, when the U.S. government or large American corporations issue bonds to raise capital that is then purchased by foreign investors, those payments will also have to be made in dollars. This also applies to the purchase of U.S. corporate stocks from non-U.S. investors, requiring the foreign investor to sell their currency to buy dollars to purchase those stocks.

These examples show how the U.S. creates 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 is considered a safe haven during times of global economic uncertainty, so the demand for dollars can often persist despite fluctuations in the performance of the U.S. economy.

2. Sentiment and Market Psychology of Dollar Value

In the case that the U.S. economy weakens and consumption slows due to increasing unemployment, for instance, the U.S. is confronted with the possibility of a sell-off, which could come in the form of returning the cash from the sale of bonds or stocks in order to return to their local currency. When foreign investors buy back their local currency, it has a dampening effect on the dollar.

3. Technical Factors that Impact the Dollar

Traders are tasked with gauging 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 any news or events that may impact the dollar's value. This includes the release of various government statistics, such as payroll data, GDP data, and other economic information that can help us to determine whether there is strength or weakness in the economy.

In addition, we need to incorporate the views of larger players in the market, such as investment banks and asset management firms, to determine the general economic sentiment. Sentiment will often drive the market rather than the economic fundamentals of supply and demand.

To add to this mix of prognostication, traders are tasked with analyzing historical patterns generated by seasonal factors such as support and resistance levels and technical indicators. Many traders believe that these patterns are cyclical and can be used to predict future price movements.

Bringing Factors Together

Traders typically adopt some combination of the methods outlined above to make their buy or sell decisions. The art of trading exists in stacking the odds—in the form of congruence in the three methodologies—in your favor and building an edge. If the probability of being correct is high, the trader will assume the risk of entering the market and managing their hypothesis accordingly.

An Example of a Dollar Value 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, the government had to take up the slack by increasing spending and propping up the economy.

The purpose of government spending was to create jobs so that the consumer could earn money and increase consumption, thereby fueling the growth needed to support economic growth.

The government took this position at the expense of an increasing deficit and national debt. In short, the government essentially printed money and sold government bonds to foreign governments and investors to increase the supply of dollars, resulting in the currency's depreciation.

The Bottom Line

Outside of paying close attention to market sentiment and technical factors such as government data, 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.

A trader can develop a big picture sense of the flow of dollars and form an insight on how best to select profitable trading positions by watching the patterns on the chart and as mentioned above, listening to the major fundamental factors that affect supply and demand.