Balance of trade and investment
The balance of trade and investment is often cited by analysts as the most important influence on the value of the dollar, with good reason. The balance of trade, related to the current account, represents the difference between what the US exports and imports in terms of goods and services.
The balance of investment, or financial account, represents the difference in exports and imports of capital. If exports exceed imports, in either the current account or financial account, it is called a surplus. When imports exceed exports, on the other hand, it is referred to as a deficit. The following points elaborate on how the current account and financial account affect the USD.
- Balance of trade: Otherwise known as the current account balance, the trade balance is equal to the difference between imports and exports. The US has been running a trade deficit with the rest of the world for most of recent memory. At $2 billion a day and growing, the trade deficit is making foreign investors increasingly nervous and can affect the dollar significantly.
- Falling prices on foreign goods: When the prices of foreign goods decrease, they become more attractive to American consumers, creating a larger trade deficit. Conversely, a rise in the prices of foreign goods, through natural price inflation or because or increased demand, can make American goods look more attractive and help to narrow the trade deficit. This also supports American industry and the economy. All of this serves to help the dollar.
- Balance of investment: When the US imports more than it exports, it means investors from other countries have to buy US assets to keep the dollar from falling. Simply stated, if the US imports more than it exports, foreign investors must buy dollar-denominated assets like bonds or treasury securities in order to offset the difference.
Government policies often have a great impact on the value of the dollar. Savvy foreign investors know to keep an eye on the state of our political affairs, especially as they impact the strength of our economy and our ability to service the national debt.
- Budget deficit and national debt: The US government’s budget can affect the dollar’s value, too. If foreign investors see that the government is spending more money than it currently has, they know that it will be forced to borrow from future generations as well as from the private sector from foreign entities. The US national debt currently stands at $9 trillion and is growing by over $1 billion per day.
- Little or no default on debt: When the government keeps a good credit history, risk goes down and the dollar goes up. Fortunately, the US is currently considered the world’s most credit-worthy borrower, which in large part explains why the dollar has remained strong.
- President’s popularity: Often, the popularity of the US president is tied to the value of the dollar. Experts debate whether or not the two have an effect on each other, but reports point out that “international investors like to a see a strong U.S. executive because they prefer a single national decider setting the agenda and fear a fractious, parochial Congress.”
- Terrorist attacks and war: Attacks damage consumer and business confidence, hampering economic growth. They also increase the likelihood of war, and consequently, a budget deficit to support associated spending. An ongoing war can quickly become expensive. It makes investors nervous because it will likely increase our national debt, and slightly increase the risk of default.
- Geopolitical events: Anything that could be seen as precipitating a conflict or foreign involvement can affect the dollar negatively. The value isn’t necessarily about what it’s actually worth, but rather what investors think it’s worth. Perception is often reality in the forex markets.
- Consistent policies: If investors feel that things will largely stay the same, they’ll flock to the dollar because it’s a safe bet. This increases demand and thus, the value of the dollar. Remember, unlike many other investment vehicles, forex is hurt by volatility. This is especially true with regard to financial policy: if investors believe US policy is on the right track, they’ll want to put money in dollar-denominated investments. Conversely, investors can lose faith in an economy that can change with new policies, so they’ll see the dollar as less of a safe bet.
- Government expansion: New departments and increased government functions cost money, too. Like other government expenses, expanding or creating new groups like the TSA and the Department of Homeland Security can lower the dollar’s value due to their opportunity cost against other expenses in the budget.
- Elections: Confidence in or wariness of a new administration can cause investors to flock to or flee from the dollar. Also, as new members of Congress are elected, new laws are passed which can affect our economy. Foreign investors may react positively or negatively to these changes, affecting the dollar’s value.
- Tax cuts for consumers: Tax cuts for consumers fuel spending, which can improve the economy of our country as well as others, like China. This can be good for the dollar as long as it does not deepen the trade deficit or our budget deficit. On the other hand, increases in taxes discourage personal spending, but they help with government spending and debt. This can slow the economy, but at the same time lessen our deficits.
Political impact on the dollar does not originate entirely from the US; it can come from all over the world. Trade, conflict, consumption, and other issues can affect the dollar from outside our country.
- Turmoil in other countries: When other countries are in a state of conflict, their respective currencies may be perceived as unstable. In this case, investors may flock to the dollar because it is considered a safer bet.
- Stability in other countries: On the other hand, if other countries are consistent in their policy-making as well as politically and economically stable, the dollar may weaken because investors have more confidence in these alternative currencies. They’ll see them as less risky and diversify into non-dollar denominated assets.
- A change in foreign reserves: The USD benefits strongly from being the world’s reserve currency. Most central banks hold more dollars than any other currency, but the dollar faces problems when they decide to diversify their currency investments. This could mean that they sell dollars, or simply just stop buying more. This is especially damaging when a large purchaser like China decides to stop adding to its foreign reserves.
- A strengthening Euro: The dollar faces competition from the rising Euro. It’s an attractive alternative to the dollar when investors choose to diversify or if the dollar becomes unstable.
- Acceptance of oil in dollars: As long as the majority of world oil contracts are settled in USD, other countries have to use the currency. This increases demand for the dollar and therefore, its value. Additionally, most oil exporters hold a significant portion of their oil proceeds in dollars.
- Strong foreign economies: If other countries’ economies are booming, the dollar may fall because it will become a relatively less attractive place to invest.
As a significant government expense, entitlement programs can have a large impact on the way investors view the value of the dollar. If it looks like the US is letting things get out of hand, these programs can shake the confidence of investors. These are a few of the programs and issues that affect the dollar.
- Social Security: It’s apparent to Americans and foreigners alike that Social Security is a sinking ship that will only get worse with time. Clearly, this causes investors to lose faith in the US money management system, but when the US works to reform the program, some of this confidence is restored and the dollar can benefit.
- Medicare/Medicaid: Like other costly entitlements, government sponsored-health care programs are becoming difficult to maintain, which could drive investors to seek countries with more stable budgets.
The laws of supply and demand are ever-present in economics, and currency trading offers a prime example of this law in action. These are a few of the effects that supply and demand exert on the value of the dollar.
- Demand for dollars: This factor can be tied to most others, but it can function on its own as well. For example, “if French investors saw an opportunity in the U.S., they might be willing to pay more francs in order to get dollars to invest in the U.S.” More francs per dollar means the dollar’s value has risen.
- Demand for physical currency outside the US: Some countries accept dollars as a physical currency, so they need a supply. For example, “large international demand for US currency bills in the 1990s gave the US government a unique and inexpensive-to-produce export.” Although it requires supplying more currency, this is a factor that can strengthen the dollar’s value.
- Increase in money supply: With every new dollar printed, each one is valued less than before. The more dollars there are in circulation, the less the currency is valued because the supply has been increased. In practice, this usually causes inflation, which directly eats into the value of the dollar. While this would seem difficult to measure, the Federal Reserve periodically publishes M2 and M3 data reports on the US money supply.
Just like consumers might shop around for the highest-yielding savings account, foreign investors look for the best deal in currencies. Here’s how interest rates affect the dollar’s value.
- Rise in interest rates: Higher interest rates mean more profit for investors, so a US rate hike will generally strengthen the dollar. In the long-term, however, the law of interest rate parity dictates that currency valuations and interest rates should move in opposite directions. The opposite also holds true. If the Fed lowers interest rates, investors might drop the dollar in the short-term because there’s not enough profit in it.
- Attractive interest rates in other countries: Regardless of whether US interest rates are rising or falling, the dollar’s value also depends on how US interest rates stack up to those of other countries. If US rates are lower, investors may switch to different currencies that can offer a better return. On the other hand, if other currencies have unattractive interest rates, that allows us to entice investors with a better deal.
- News about interest rates: Investors like to be ahead of the game, so if news of an interest rate hike or fall is released, the dollar may fluctuate in response to the coming inflow or outflow of investments that are expected to happen in the future.
American consumers have the most at stake in the dollar’s value. A fall in the dollar makes consumers’ money worth comparatively less, putting a squeeze on the budgets of the Average Joe. Yet there are several things that consumers do that serve to drive down the buying power the dollar. Here’s how Americans do it.
- Consumer savings: Americans aren’t big on savings. In fact, most families have a negative net worth. While this has contributed to a strong economy in the short-term, it means the US is ill equipped to support the economy in the long-term. Additionally, negative domestic savings drives us to import foreign savings, which harms the dollar.
- Gas prices: Rising gas prices leave consumers with less money to spend elsewhere, or worse, drive them to borrow money to keep up their standard of living.
- The Walmart/Honda factor: When Americans buy foreign goods like items at Walmart or Honda cars, we contribute to an economy that supports more imports than exports. This creates a trade deficit that weakens the dollar.
- Slow spending: Just as too much spending can hurt the dollar, too little spending can have a negative effect as well. Analysts report that when we hit a slow shopping season, “the Fed might see that as a sign of consumer fatigue and choose to cut rates in an attempt to stimulate growth. That could hurt the dollar.”
Recently, we’ve seen how a housing boom and subsequent bust can cause problems for families, investors and lenders in the form of defaulted loans and drops in the value of homes. These same issues cause problems for the dollar, too.
- Slow housing market: A slow housing market creates a domino effect. Sellers are forced to lower their asking prices, which creates a decline in household spending and results in slowed economy growth, all of which hurts the dollar.
- Strong housing market: A growing, steady housing market builds the equity and net worth of home owners, spurring spending and growing our economy. This supports the dollar.
- Overinflated housing market: This kind of housing market results in a fall of equity and personal wealth, but it doesn’t stop there; it makes the dollar fall as well, as the effect of declining home prices ripples throughout the economy.
Industry and economic indicators
American industry both affects and reacts to the value of the dollar. When the dollar falls, our goods become cheaper and more attractive. However, when we have a strong dollar, our industries have to compete harder against cheaper foreign labor and goods.
- Low growth in manufacturing: Manufacturing levels serve as an indicator for the health of the US economy. An industry slowdown means a general slowing in the economy and can cause investors to become wary of the dollar.
- Strong manufacturing growth: Conversely, strong manufacturing growth can indicate that the economy is picking up, creating a more attractive dollar.
- Outsourcing: Outsourcing creates a trade deficit and causes US employment to suffer, resulting in a fall of the dollar. However, outsourcing also makes US companies more profitable and more attractive targets for foreign investment.
- Entrepreneurship: Entrepreneurship creates attractive investment opportunities for foreign investors, supporting a stronger dollar.
- Employment growth: Like manufacturing growth, employment growth is a good indicator for the overall health of the economy. Positive employment growth will attract more investors and create a stronger dollar. Unnaturally high unemployment causes the dollar to drop because the government loses tax revenue that could help with the deficit. It also takes consumer purchasing power away, which causes the economy to suffer.
- Wage data: Higher or lower wages can either attract or scare off investors, creating a fluctuation in the dollar’s value.
US capital markets
US stocks, bonds, and other investments can be appealing no matter where you are in the world. The performance of US capital markets can either attract or reduce foreign investment, which directly affects the dollar.
- Bear markets: Falling values create investment losses that shake investor confidence and cause them to diversify or liquidate their portfolios, resulting in a loss for the dollar if the diversification involves an exodus from dollar-denominated assets.
- Bull markets: Strong market values have the opposite effect, creating profits that attract new investors and encourage current investors to put more money into dollar-denominated assets. A booming market can attract investors, but it can also cause the dollar to fall when it corrects itself and investors pull out.
- Accounting scandals: Accounting scandals like Enron can burn investors and cause foreign investment in US stocks to fall.
The current performance of the US economy is synonymous with the financial health of our nation. It signals to investors our ability to pay back debts as well as the profit level they may earn.
- Economic growth and stability: In general, a strong economy will raise confidence, assuring foreign investors that they’ll earn a good profit on a stable investment. Economic growth is even better, attracting investors who hope that their investment will grow, too. A boom in the economy can cause an investment rush that results in a temporary overvalue of the market. This can lead to a dollar loss when it corrects itself in a slow of the economy.
- Economic recession: What goes up must come down. A slowing economy hurts the dollar, causing investors to pull out for fear that their investment will lose value.
- Outperforming other economies: Economic performance is all relative. If the US economy is stronger than others, investors may turn to the dollar as a safe bet.
Weather affects the agricultural industry, energy consumption, and local economies. Any change, for better or for worse, can create a ripple affect that impacts the economy as a whole and causes the dollar to fluctuate.
- Unfavorable farming conditions: Unfavorable farming conditions can result in slow crops and force grocers to turn to other countries to satisfy US agricultural needs. This further opens up the trade deficit and weakens the dollar.
- Unusually hot summers: An unusually hot summer can cause a rise in energy costs for both consumers and industries. This can create a strain on the economy and cause the dollar to fall. Just like an unusually hot summer can sink the dollar, an excessively cold winter can do the same thing. It can cause energy costs to rise, and since must of our energy is imported, the dollar may be adversely affected. Additionally, consumers will presumably have less disposable income to pour into other areas of the economy.
- Natural disasters: Natural disasters like Hurricane Katrina create a strain on local economies as well as the local and federal government as we work to repair damage and spend money on relief and rebuilding. This can cause the dollar to struggle.
Inflation directly eats into the value of the dollar. The law of purchasing power parity (PPP) holds that a nation’s currency and its general price levels should move in opposite directions.
- Slow in inflation of foreign goods: A slow in inflation of foreign goods keeps prices of those goods steady, allowing American consumers to purchase the same amount or more of the same goods. This does not help to close the trade deficit and can weaken the dollar.
- News about inflation: Of course, any news about possible inflation of the dollar or foreign goods can cause the foreign exchange market to react preemptively and fluctuate the dollar one way or another.