The decision to buy or sell dollars boils down to assessments of how the U.S. economy is performing. A strong economy attracts money from investors who perceive safety and an opportunity to achieve an acceptable rate of return. Investors typically seek the highest yield that is predictable or “safe.”

Investment from abroad creates a strong capital account and a resulting high demand for dollars. On the other hand, American consumption that results in importation of goods and services causes dollars to flow out of the country. If imports exceed exports, a nation has a deficit in its current account.

With a strong economy, the United States can attract foreign capital to offset its trade deficit, and American consumers can continue serving as the consumption engine that drives the world’s economies, even though the U.S. is a debtor nation. This also allows other countries to export to the United States and keep their economies growing.

This explanation is simplistic, but it illustrates a point.

When it comes to taking a position in the dollar, a currency trader needs to assess the factors influencing the value of the greenback to try to determine a direction or trend.

There are three main factors: supply and demand, investor sentiment, and technical indicators. Let’s take each factor individually.

Supply and demand

When we export products or services, we create a demand for dollars because our customers need to pay for the goods and services in dollars. Hence they sell their currency to buy the dollars needed to make their purchases.

Similarly, overseas investors often exchange their currencies for dollars when they want to buy U.S. government or corporate bonds, or shares in publicly traded U.S. companies.

Investor sentiment

But what if the U.S. economy weakens and consumption slows due to increasing unemployment? Then the United States is confronted with the possibility that foreigners may sell their U.S. bonds or stocks and convert cash from the sales into their local currencies.

Traders need to consider what other players in the market think about the likely outcome of events. Very often, sentiment plays a bigger role in driving the market than do supply and demand.

Technical data

Traders must gauge whether the supply of dollars will be greater or less than the demand for them. Hints can be gleaned from the news and regular reports from the government on such things as gross domestic product, personal income and employment. These data can help traders determine whether the economy is strengthening or weakening.

Beyond daily events and the regular release of economic data are historical patterns generated by seasonal factors, longer-term support and resistance levels, and so on. Many traders believe these patterns are repetitive and therefore can be used to predict movements.

Bringing it together

Because trading relies on the ability of a trader to take a risk and manage it appropriately, traders usually adopt some combination of these factors in making their buy or sell decisions. The art of trading exists in stacking the odds in your favor. If the probability of being correct is sufficiently high, the trader will enter the market and manage his or her hypothesis accordingly.

Economic conditions during the recession that began in 2007 caused the U.S. government to play an unprecedented role in the economy. Because economic growth was receding as a result of a deleveraging of financial assets, the government took up the slack by boosting public spending. The goal was to create jobs so that consumers could continue to spend, thereby fueling the activity needed for a resumption of economic growth.

The government took this position at the cost of increasing the deficit and the national debt. It financed its spending by essentially printing money and selling government bonds to foreign governments and investors. The dollar initially fell in value as a result.

Another concern is the increasing interest-rate burden that accompanies a rising debt level. Investors and others worry that an increasing share of federal tax revenues will have to be allocated to meet interest payments, leaving less money for more-productive purposes. One of government’s most important roles is to foster economic conditions that allow for something close to full employment while keeping inflation in check.

It may be helpful for a trader to keep an eye on currency rates to track how the dollar is faring against the other currencies. By observing patterns, paying attention to market sentiment and monitoring the major fundamental factors that affect supply and demand, a trader can identify profitable positions in future trades.

This article was reported by Selwyn Gishen for Investopedia.

Published March 12, 2010

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