There are thought to be four mechanisms at work:

1. When a needle enters the tissues it causes mild trauma (in the same way that deep massage does) which triggers the inflammatory process. This sounds like a bad thing, but as the inflammatory process and the healing process are the same thing, so the needle actually stimulates healing.
2. Part of the inflammatory process also involves the production of the body's natural pain killers (endorphins).
3. There is also a neurological pain killing effect. Inside the spinal cord there is a structure called the 'pain gate' which monitors pain information entering the spinal cord and can block some or all of it if necessary. An example of this is that a small cut on your finger can sometimes be very painful whereas a deep cut can be bizarrely painless. A needle also triggers pain nerves at a very low level and this, in turn, stimulates the 'pain gate' to close slightly which has two effects: firstly it reduces muscle tightness and spasm (increases blood supply and therefore healing) and secondly reduces pain levels. It is this combination of pain reduction and, very importantly, stimulation of healing processes that make dry needling such an effective treatment.
4. Not to be forgotten is the placebo effect, which can be extremely powerful and comes in to play in any therapeutic intervention. Note that the placebo effect doesn't just make people think that they are better, it actually causes healing to occur. This is why drug companies spend so much time and money trying to eliminate it with their double and triple-blind medical trials.