Posted by Adam Solomon on May 31st, 2017.
The US Dollar (USD) is everywhere, ingrained in most countries’ economies in some form or another, and dominating since the end of WWII as the world’s premier reserve currency. So prevalent is USD that the term ‘Dollarization’ was developed to describe the spectrum of ways in which the currency can be integrated by a nation. This can range from USD being the only legal tender of a nation (think Panama, Ecuador), nations using both USD and their own currency as legal tender (Cambodia), and the US Dollar simply being acceptable in private transactions without being officially categorised as legal tender.
The prevalence and relative stability of the US Dollar makes it an attractive investment, but it doesn’t mean the currency isn’t subject to volatility. There are a number of factors that can cause US Dollar movement, and they range from fundamental and technical aspects to market psychology and monetary policy outlook. All of these elements, however, result in the movement of currencies through the central principal of supply and demand.
The foreign exchange market, like all markets, is ruled by the laws of supply and demand. In layman’s terms, supply is the measure of how much of any commodity, service, or currency is available at any particular time, and demand is, of course, how much demand there is for the thing in question. The two are intrinsically linked; in theory, when one increases (or decreases!), the other weakens. In the real world there are numerous other factors that can alter prices without supply and demand having to move in opposite directions. However, supply and demand is the foundational driving force of market movements.
Generally speaking, if supply outstrips demand, the price falls, and vice versa. This simple concept is extremely important, and the impact of all economic reports, political upheavals, etc, can be assessed in the following terms: Will the response from investors to a report, comment or a political/economic/social development, lead to an increase in demand for USD (because investors want to buy it) or a rise in supply (because investors will want to sell it)? The former makes the currency’s value rise, while the latter weakens the US Dollar. As you can imagine, this is somewhat of a self-fulfilling prophecy – the psychology of investors anticipating a rise or fall influences the fluctuation of the currency.
We’re getting into macroeconomics now, but don’t panic. Purchasing power parity (or PPP) is essentially an analysis that compares how much a basket of goods is worth across two countries in relation to the exchange rate. If the goods are priced equivalently across both countries, then the currencies are considered to be in equilibrium – equal bang for your buck. Some traders will monitor currencies in this regard to see if they’re undervalued or overvalued, with undervalued meaning that the currency buys less in goods and services than the one it’s paired with, and vice versa.
One well known example of this is the Big Mac Index by The Economist, which replaces the ‘basket of goods’ with a Big Mac and monitors its price across a range of countries relative to the domestic exchange rate. This is a somewhat simple way of understanding PPP. For instance, if a Big Mac is $3 in America, and £2 in Great Britain, then the currency’s ‘fair value’ should be 1.5 Dollars to the Pound. If the exchange rate is lower than this, however, then investors will make note and potentially base future trading decisions on the possibility that the US Dollar will appreciate in value to correct this discrepancy.
When making currency transfers traders have to decide whether the supply of US Dollars, upon entering the market, will be greater or less than the demand for US Dollars. The best way to do this is to keep a keen eye on the various news items, government statistics and industry reports that are released. This is called ‘fundamental’ analysis, and it provides keen insights into the health of an economy. Typically, economic reports which indicate that an economy is performing well give the domestic currency a boost, while reports which imply it is struggling undermine demand for the domestic currency. Not only are the results themselves important, but forecasts for what the results could be are significant, with expectations often having an impact on currency movement ahead of the data’s release. Here are some of the reports to keep your eye on!
Release Schedule: Monthly
This report is a measure of how well retail goods are selling over a specific time period. Robust sales figures point to a high demand for US goods, which suggests a healthy economy and confident consumers. Conversely, low sales suggest an unhealthy economy. The more demand there is for US goods, the more the US Dollar can gain in value on the back of a retail sales report.
Release Schedule: Monthly
These figures detail the volume of industrial goods produced by firms such as mines, factories, utilities, newspapers, and book publishers on a monthly basis. The data from this report generally illustrates growth or contraction in a similar fashion to the Retail Sales report, with strong industrial production figures potentially inspiring gains for the ‘Greenback’, while weak figures prompt a more bearish outlook.
Release Schedule: Quarterly
GDP is a measure of the value of all finished services and goods that are produced within a country’s borders during a set period of time. When GDP is on the rise, it indicates a strengthening economy. Often interest rates and the domestic currency will rise if GDP is rising, as an increase in GDP attracts foreign investors (increasing demand). If GDP falls, however, the US Dollar tends to fall with it.
Release Schedule: Monthly
The Consumer Price Index is a measure of price fluctuations on the weighted average of a set of goods and services called a ‘basket of goods’. If the price of goods is rising during a given period (leading to a decrease in the purchasing value of money) it is known as inflation. If the price of goods is falling over a given period it is known as deflation. Controlled inflation is good for an economy, and national central banks aim to keep inflation in line with a set rate through the use of monetary policy. Deflation is typically bad for an economy and can have a significant impact on growth and stability. CPI reports which show that US inflation is in the region of the Federal Reserve’s target levels are therefore good for USD.
Release Schedule: Monthly
This report focuses on labour statistics for the US and can have a notable impact on USD exchange rates. Some of the most significant statistics include the unemployment rate, the number of jobs added since the previous month (known as ‘Change in Nonfarm Payrolls’) and average hourly earnings. Improvements in the key measures of the NFP report tends to mean positive things for USD.
Sentiment, expectation, panic and psychological perspectives can all have a huge impact on the value of the US Dollar. If the US Dollar is expected to weaken in the future, then traders and investors are likely to sell, and vice-versa. In regards to political announcements, they are often harder to interpret than strict data. However, it is often enough simply for a news item or political event to be perceived as a negative for the currency for the value of the US Dollar to decrease. Investors want a return on their investment, so if a change is perceived as having potential to weaken demand for the US Dollar, they will sell!
Ultimately, currency movements can be complicated, unexpected and dramatic. The US Dollar can fluctuate in response to changes in supply and demand and market sentiment, both of which can be influenced by the perceived threat/benefit of information from economic releases and political fluctuations.
While there are a number of other factors that can cause US Dollar movement (the currency market is, after all, notoriously volatile) hopefully this article has provided you with a brief overview of some of the main things to look out for!
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