3 factors driving the US dollar

A country with a strong economy will attract investment from around the world. Investors will see safety and the ability to achieve an acceptable rate of return on investment. As investors seek the highest returns, an increase in investment, especially from abroad, creates a strong capital account and a strong demand for US dollars.

Key takeaways

The US dollar was a reserve currency for international trade and finance.Like any other fiat currency, the dollar’s value depends on the economic activity and outlook of the United States. In addition to supply and demand and market factors, sentiment affects the dollar’s value on the global market.

What affects the dollar’s value?

American consumption by importing goods and services from other countries causes dollars to flow out of the country. If US imports are higher than exports, the country will have a current account deficit.

With a strong economy, a country can attract foreign capital to offset the trade deficit. This allows the US to continue its role as the consumption engine that fuels world economies, even though it is a debtor nation that borrows this money to consume. It also allows other countries to export to the US and grow their economies.

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

Investopedia / Alex Dos Diaz

1. Offer vs. Question

When the US exports products or services, it creates a demand for dollars because customers must 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 US corporations issue bonds to raise capital and bonds are bought by foreign investors, those payments are made in dollars. This also applies to the purchase of US corporate shares from non-US investors, which requires foreign investors to sell their currency to buy dollars to buy those shares.

Safe harbor

A safe haven is an investment that is expected to maintain or increase in value during market turbulence. The US dollar is considered a safe haven during times of global economic uncertainty, so demand for dollars often persists despite fluctuations in the performance of the US economy.

2. Sentiment

When foreign investors buy back their local currency due to market turbulence, it dampens the dollar. Rising unemployment could weaken the US economy, and consumption could slow. The US could 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 general economic sentiment. Sentiment will often drive the market rather than the economic fundamentals of supply and demand.

3. Market indicators

Traders measure 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 affect 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.

What causes the US dollar to rise?

When demand for the dollar increases, so does its value. Conversely, if the demand decreases, the value also decreases. The demand for the dollar increases when international parties, such as foreign nationals, foreign central banks or foreign financial institutions demand more dollars. Other factors that affect whether or not the dollar appreciates against another currency include inflation rates, trade deficits, and political stability.

What factors affect the exchange rate?

Factors that affect the exchange rate between currencies include foreign exchange reserve status, inflation, political stability, interest rates, speculation, trade deficits and surpluses, and government debt.

Can the US government determine the value of the dollar?

The US Treasury and the Federal Reserve cannot dictate the value of the US dollar. The value is determined in foreign exchange markets. However, as the value shifts on the stock market, the movements help the Fed determine monetary policy.

The Bottom Line

Traders can follow the Dollar Index chart to see how the dollar is doing 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 main fundamental factors that affect supply and demand.

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