All currencies are connected in a global currency market; one currency’s relative value impacts another’s value. Some currencies, like the US Dollar (USD), are strong enough to impact many currencies and economies at once, directly or through a ripple effect. The USD is the world’s reserve currency widely used and accepted for exchange, trade, investment, and settlement.
Why Monitor the USD?
Many foreign exchange traders, local and international companies, governments, and financial institutions monitor the USD exchange rate to make important decisions. However, it is more effective to predict the future prices of the Dollar based on historical data and analysis of factors that impact its price.
These factors are either economic or non-economic but impact the value of the USD. They are constantly monitored through various mediums and highly accurate tools. You’ll find that your forex broker likely has a feature for finding news about them.
Let’s take a closer look at some factors that impact the Dollar.
Economic Factors
These are directly related to the economy and have a two-way relationship with the exchange rate. The economy is monitored through payroll data, GDP data, and other economic information.
Interest Rates
A country’s monetary policy allows the apex bank (The Federal Reserve Bank) to control economic conditions by raising or lowering the interest rate. When the interest rates rise, the USD becomes more attractive to investors as they can earn higher returns on their investments. This causes an increase in the demand for the Dollar and also increases the exchange rate. Increased value leads to increased demand.
Conversely, a fall in the interest rates may signal a fall in the expected returns on USD investments, leading to a fall in the exchange rate as investors hurry to sell their USD holdings to mitigate potential losses. Interest rates impact the Dollar and remain the most prominent factor many investors monitor. For example, the interest rate may be increased to stimulate economic recovery despite poor economic conditions.
Inflation
Inflation is the rate at which the prices of goods and services increase; a sharp increase may outpace the economic growth rate and, therefore, cause people to lose their purchasing power and financial value quickly. A high inflation rate causes the purchasing power of the Dollar to fall and takes the demand with it. This is a significant concern as sustained periods of inflation may lead to economic recession.
Controlling inflation is a major way the Federal Reserve Bank controls the exchange rate of the USD. Although high inflation is undesirable, zero and negative inflation (deflation) are also not desired, so the Reserve Bank aims to keep inflation at optimal levels, typically between 2%.
Economic Growth
The economic situation of the US also affects the USD. When the economy grows and is conducive for businesses, investors get attracted and seek investment opportunities in the US. This can lead to an increase in the exchange rate. If the opposite happens, the economy may lose its attractiveness to investors and cause a slump in the USD’s value.
The US government, therefore, prioritizes economic growth to keep local and foreign investments safe and flowing. This involves making and implementing policies, providing security and business infrastructure, and removing administrative bottlenecks.
Other notable factors are the debt-to-GDP ratio, trade balances, and supply and demand.
Non-Economic Factors
These factors are not directly dependent on the economy and result from third parties.
Investors’ Sentiment
How investors feel about a particular market, asset, or investment vehicle would impact their investments. When investors are confident and optimistic, they are more likely to buy the Dollar, increasing value. If they are not confident and feel negative about the economy, they may sell their USD holdings or stay off the market for a while.
Investors’ sentiments are not always dependent on the immediate market; they may be playing the long-term game and use that sentiment for the present. Attracting investors and keeping their sentiment positive helps the Dollar.
Geopolitical Risk
The political risk of economic instability in a region or country also impacts the US. Where geopolitical risks are high, investors may sell other currencies or assets and convert their financial value to the US Dollar, a so-called “safe-haven” currency. This is a way of hedging against inflation and other economic issues associated with geopolitical risk.
If, on the other hand, geopolitical risk is low enough to encourage other riskier investments, inventors may sell part or all of their US Dollar holdings to invest in those riskier options. Local and international geopolitical stability is important in the strength of the USD.
Examples of Factors Impacting the US Dollar
Here are some examples of how these factors impact the USD:
- Rising Interest Rates: The US Dollar increased against the Euro in the last six months — thanks partly to increased interest rates — making the USD more attractive to investors. The Federal Reserve Bank increased the interest rate from 4.33% in January 2023 to 5.50 % in August 2023.
- Geopolitical Concerns Pushed Investors to the US Dollar: The current war on Ukraine has increased the geopolitical risk in Europe and global markets, forcing investors to move to the US Dollar and other safe-haven currencies.
- Concerns about an economic recession in the US also caused investors to buy the USD. Investors have held negative sentiments recently due to concerns about a potential recession.
These factors combine to impact the USD; the current exchange rate results from all combined factors affecting the demand and supply.
Conclusion
The Dollar holds a strong position in the global forex market and impacts the value of many other currencies. A major change in the USD exchange rate ripples through the market. If you trade the financial markets or do business, monitor the US Dollar and related trading pairs to make the right trading decisions. You can monitor economic data from your broker or find reliable third-party providers.
