3 Factors That Drive the U.S. Dollar

A country with a strong economy will attract investment from around the world. Investors will perceive safety and the ability to achieve an acceptable rate of return on investment. Since investors seek out the highest yield, an increase in investment, particularly from abroad, creates a strong capital account and a high demand for U.S. dollars.

What Affects the Dollar's Value?

American consumption through imports of goods and services from other countries causes dollars to flow out of the country. If U.S. imports are higher than exports, the country will have a deficit in its 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 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.

When the dollar is traded, three factors can drive its value, including supply and demand, market sentiment, and technical market data.

1. Supply vs. Demand

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. Global consumers convert local currency into dollars by selling their currency to buy dollars to make the payment.

When the government or American corporations issue bonds to raise capital and bonds are purchased by foreign investors, those payments are made in dollars. This also applies to the purchase of U.S. corporate stocks from non-U.S. investors, requiring foreign investors to sell their currency to buy dollars to purchase those stocks.

2. Sentiment

When foreign investors buy back their local currency due to market turbulence, it dampens the dollar. Increasing unemployment may weaken the U.S. economy, and consumption may slow. The U.S. may face a dollar sell-off, where global investors return the cash from the sale of bonds or stocks to return to their local currency.

Investment banks and asset management firms analyze trends and often determine the general economic sentiment. Sentiment will often drive the market rather than the economic fundamentals of supply and demand.

3. Market Indicators

Traders gauge whether the supply of dollars will be greater or less than the demand. To help us determine this, they pay attention to news or events that may impact the dollar's value. This includes various government statistics, such as payroll data, GDP data, and other economic information.

Traders also review 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.

The Bottom Line

Traders can follow the Dollar Index chart to see how the dollar fares against other currencies. A trader can develop a 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 listening to the major fundamental factors that affect supply and demand.