What factors affect the value of the US dollar?

What factors impact the value of the dollar?

There are six fundamental factors that have an influence on the US dollar exchange rate. These include things such as economic performance, supply and demand of currency, inflation, and geopolitical factors. More details on each of these factors are detailed below.

Learn more about forex (FX)

Moves in the federal funds rate

The federal funds rate is the interest rate at which commercial banks lend extra reserves to one another on an overnight basis. The target rate is set by the Federal Reserve’s Open Market Committee (FOMC), and it serves as the base interest rate to control the supply of money in United States.¹

Regulations governing commercial banks in the US require that a certain percentage of total funds deposited are held in reserves. This requirement ensures the assurance of bank’s financial stability and solvency.¹

In a constantly changing environment, banks may find themselves with an excess or shortfall of the required daily reserves. When facing a shortfall of reserves, banks take out overnight loans from their peers, and when they have excess reserves, banks will also lend to their peers.¹

The federal funds rate has an impact on inflation, short-term and long-term interest rates, as well as foreign currency exchange rates. It is used to control these costs. The higher the federal funds rate, the more expensive bank loans, home loans, mortgages, and credit cards will be to pay back.²

Above and beyond its effect on other interest rates, the federal funds rate also serves as the base interest rate to control the money supply within the US economy.² When there is a higher demand for the US dollar, which often occurs when there is a shortage of the currency, its monetary value increases.

When the federal funds rate increases, the cost of borrowing also rises, which can have both positive and negative impacts on the economy. One hand, it can boosts the economy’s wealth, but on the other hand, it can help curb the rise in inflation.

Learn more about the Federal Open Market Committee

Demand for currency

The US dollar has been predominantly used as a currency peg, which occurs when a government policy implements fixed exchange rates for its national currency and another country’s currency, in this case, the US dollar. Some countries that use the US dollar as a medium of exchange include Ecuador, Puerto Rico, and Zimbabwe.

The use of the US dollar as a dominant currency increases its demand, making it the world’s reserve currency as most countries use it for the global trade of commodities. Central banks and major financial institutions hold reserve currencies to facilitate global transactions and mitigate risks associated with exchange rates.³

However, over the years, alternative currencies have emerged as a potential threat to the US dollar’s status as a reserve currency. These alternatives include the euro, Japanese yen, British pound sterling, as well as smaller reserve currencies like the Canadian dollar and Australian dollar.³

Although these alternative currencies have a relatively small market share as reserve currencies, they are gradually eroding the dominance of the US dollar and could have negative impact on its future demand.³

Learn more about the most traded currencies in the world

Inflation

Inflation is the rate at which an economy’s currency loses its purchasing power over time. A weaker dollar would increase the price of imports, leading to a rise in inflation. This would place more pressure on the US economy, which is already grappling with rising inflation and potentially limits consumer borrowing.³

The government tends to increase the federal funds target rate, subsequently leading to a rise in short-term interest rates. This raises the cost of credit, which increases the economy's wealth as the supply of money is reduced. However, it also discourages consumers and businesses from taking out loans, encouraging saving and potentially earning higher interest rates.⁴

An economic cycle shows how inflation affects the financial markets. There is an increase in interest rate when the economy grows and a decrease when the economy contracts.

For instance, the cost of a Mars chocolate bar you buy today is likely to be higher than it was a year or two ago. This means that if you buy an item for S$10 today, it will cost significantly more in a year or two.

While this is a simplified example, it demonstrates the impact of inflation on the consumer’s purchasing power, which is applicable to the cost of both goods and services.

Learn about how to trade on inflation

Performance of the US economy

When the US economy performs well, the value of the dollar appreciates. The US dollar showed its resilience post-Covid-19 pandemic, bouncing back to its former glory as interest rates increase at a fast pace compared to other global economies.³ Interest rate hikes often attract foreign investors, as they can earn higher returns by investing in the US dollar.

The opposite would hold true if the US dollar price depreciated due to a weak economic performance. A significant depreciation of the dollar would negatively affect global economies. And with the depreciation of the US dollar, other world currencies like the Eurozone, China and Japan will also be devalued since their economic growth heavily rely on exports.³

Learn more about the major currency pairs

Trade balances

America’s huge current account deficit poses one of the biggest threats to the US dollar. For nearly four decades, the value of goods and services imported into the US has exceeded those being exported. This is reflected in the high inflation, subsequently decreasing the dollar’s value.³

In 2021, the US’s current account deficit increased by 33.4% ($205.5 billion) to $821.6 billion, primarily due to a widened shortfall in goods. The US also takes out loans from foreign lenders to finance itself against the deficit. This may have a negative impact on the value of the US dollar price if this global economic leader does not claw its way out of debt.^{3, 5}

Political instability and unpredictable events

When geo-political uncertainty is on the rise, investors tend to move their wealth into safer and less volatile currencies that can better withstand the. There are several of these currencies around the world – with the US dollar being one of them.

The ongoing Ukraine-Russia conflict has also led to the dominance of the US dollar as investors looked for a safer haven and a more liquid market.6 Since the beginning of the Russian invasion on Ukraine earlier in the year, the value of the US dollar has continued to strengthen.³

This comes after a period of weakness for the US dollar compared to major currencies like the euro and the British pound during the first year of the pandemic. Other major currencies include the Japanese yen, Canadian dollar, Swedish krona, and Swiss franc.⁷

Over the 12 months leading up to June 2022, the US dollar’s value increased by 12% against the euro, 9% against the pound, and 16% against the yen.⁷

In mid-May of this year, the US dollar’s weighted average value against the world’s six major currencies and appreciated by 9% since February, reaching a 20-year high. Market sentiment suggests that the dollar may reach the same level as the euro by end of 2022.⁷

Learn more about ‘war economies’

How does war affect the dollar?

The price of gold is used as a measure of the US dollar’s value and investor confidence in the currency during times of both war and peace. Challenges faced by the US dollar during times of war have prompted other nations to explore alternative forms of currency, which, if successful, could have eroded the dollar’s dominance as an international currency.⁸

Since the Korean War, which took place between 1950 to 1953, the US lost a significant amount of its gold reserves. The Vietnam War, that occurred from 1964 to 1975, saw a continued loss of reserves leading to the depreciation of the dollar.⁸

However, the short-term depreciation of the US dollar during the ongoing Iraq War that started in 2003 does not accurately reflect the value of this dominant currency during times of war.⁸

During times of war, some nations involved in the conflict tend to take advantage of the situation by trying to dislodge the US dollar from its dominant position. This was evident in 2007 when Russia tried to replace the dollar with rubles in its financial markets. That same year Iran also attempted to persuade the Organization of the Petroleum Exporting Countries (OPEC) to accept euros rather than dollars for oil.⁸

This would have reversed the geopolitical diplomatic arrangements from the 1970s and 1980s that enabled the dollar to be closely linked with gold, making it an international currency for the global commodity markets.⁸

How to trade on forex and the US dollar

1. Choose a currency pair to trade
2. Create an account or practise on a demo
3. Decide whether to ‘buy’ or ‘sell’
4. Take steps to manage your risk
5. Open your first trade
6. Monitor your position

With us, you can trade forex using a contracts for difference (CFD) trading account. Take your position on the forex spot price and FX options using CFDs which are leveraged products. Trading CFDs may not be suitable for everyone and can result in losses that exceed deposits, so please ensure that you fully understand the risks and costs involved.

When trading with leverage, you’ll need to pay an initial deposit called margin to open a position and increase your exposure to your foreign exchange currency of your choice. While leverage can magnify your profits, it can also amplify your losses – manage your risk carefully.

With us, you can trade the US dollar by choosing a forex pair that includes the American currency. Forex trading involves buying one currency while selling another based on how much each currency is valued on the FX market.

For instance, the current market price of the GBP/USD forex pair shows how many US dollars it would take to buy one British pound. Some of the other common forex pairs you can trade are the USD/CAD, USD/CHF, USD/JPY, AUD/USD and USD/NZD.

Once you have chosen the forex market to trade in, you can then open a live account with us. If you’re not confident with your trading skills, you can open a demo account with us so you can practice with S$200,000 in virtual funds in a risk-free environment. You can also use our online trading courses to improve your skills.

Factors affecting the US dollar price summed up

• The federal funds rate influences inflation, short and long-term interest rates, and foreign currency exchange rates. It is used to manage and control these costs
• Inflation is the rate at which an economy’s currency loses its purchasing power over time. A weaker dollar can lead to increased import prices, resulting higher inflation
• America’s huge current account deficit poses one of the biggest threats to the US dollar
• When geo-political uncertainty is on the rise, investors tend to move their wealth into safer and less volatile currencies that can better withstand the storm
• The price of gold is used as a measure of the US dollar’s value and investor confidence in the currency during times of both war and peace
• With us, you can choose to trade forex by using a CFD trading account

¹ Forbes Advisor, 2022
² Bankrate, 2022
³ CNBC, 2022
⁴ Forbes, 2022
⁵ Bureau of Economic Analysis, 2022
⁶ Financial Times, 2022
⁷ Econofact, 2022
⁸ The Economics of Peace and Security Journal, 2009