Ever wonder why the U.S. dollar strengthens both in times of tough luck and when the economy is booming like a Taylor Swift single?
Currencies tend to fall when their country’s domestic economic outlook worsens, but the U.S. dollar’s unique global role makes it special so when the U.S. economy isn’t doing great, the currency may still rise.
To understand why this is the case, it is helpful to pretend there are two “types” of U.S. dollars.
- There is a “domestic” U.S. dollar that behaves like any other currency. It’s linked to the economy’s relative outlook and potential investment returns.
- There is also an “international” U.S. dollar that is used as the primary currency used in global trade (for payments) and is also needed to buy U.S. government bonds which are coveted for their safety.
This “international” U.S. dollar strengthens for a variety of reasons when markets are volatile and global growth slows.
When there is some sort of “shock” that happens, whether from the U.S. or abroad, and it’s big enough to cause investors and traders to panic and send financial markets lower, then it will likely cause the broad U.S. dollar to appreciate.
In fact, this really smart dude who used to work at Morgan Stanley came up with a theory to explain this phenomenon.
What is the Dollar Smile Theory?
Stephen Jen, a former economist at the International Monetary Fund and Morgan Stanley, who now runs a hedge fund and advisory firm Eurizon SLJ Capital in London, came up with a theory and named it the “Dollar Smile Theory.”
The Dollar Smile Theory says the U.S. dollar tends to strengthen against other currencies when the U.S. economy is extremely strong OR weak.
The Dollar Smile Theory Explained
The Dollar Smile Theory is based on two assumptions:
- When the U.S. economy significantly outperforms the rest of the world, the U.S. dollar tends to be strong and increase in value relative to other currencies.
- When the global financial markets are disorderly or crashing, and sentiment switches to “risk-off“, since the U.S. dollar is perceived as the ultimate safe-haven currency, everyone rushes to safety and starts buying USD causing it to rally.
His theory depicts three main scenarios directing the behavior of the U.S. dollar.
Here’s a simple illustration:
Scenario #1: USD Strengthens Due to Risk Aversion
The first part of the smile shows the U.S. dollar benefiting from risk aversion, which causes investors to flee to “safe haven” currencies like the U.S. dollar and the Japanese yen.
Since investors think that the global economic situation is shaky, they are hesitant to pursue risky assets and would rather buy up “safer” assets like U.S. government debt (“U.S. Treasuries”) regardless of the condition of the U.S. economy.
In order to buy U.S. Treasuries though, you need USD, so this increased demand for USD (to buy U.S. Treasuries) causes the U.S. dollar to strengthen.
Scenario #2: USD Weakens to New Low Due to Weak Economy
Dollar drops to a new low.
The bottom part of the smile reflects the lackluster performance of the Greenback as the U.S. economy grapples with weak economic fundamentals.
The possibility of interest rate cuts also weighs the U.S. dollar down. (Although if other countries are also expected to cut interest rates, then this might be less of a factor since it’s all about expectations of the future direction of interest rate differentials.)
This leads to the market shying away from the dollar. The motto for USD becomes “Sell! Sell! Sell!”Another factor is the relative economic performance between the U.S. and other countries. The U.S. economy may not necessarily be horrible, but if its economic growth is weaker than other countries, then investors will prefer to sell their U.S. dollars and buy the currency of the country with the stronger economy.
It’s kind of like if you owned an NBA team and had Reggie Miller as your star player. All of a sudden, a healthy Michael Jordan is available. Obviously, you would trade Miller for Jordan because, on a relative basis, Jordan is the better-performing player.
It’s not that Reggie Miller sucks, but there’s just a better alternative at that moment. Now if you make the trade, and all of a sudden, Michael Jordan has a season-ending injury, and Reggie Miller just so happens to be available, then you know what to do.
Dump “Air Jordan” for “Miller Time”. See, it’s all relative.
Scenario #3: USD Strengthens Due to Economic Growth
The dollar appreciates due to economic growth.
Lastly, a smile begins to form as the U.S. economy sees the light at the end of the tunnel.
As optimism picks up and signs of economic recovery appear, sentiment toward the U.S. dollar begins to pick up.
In other words, the Greenback begins to appreciate as the U.S. economy enjoys stronger GDP growth and expectations of interest rate hikes increase (relative to other countries).
Let’s take a look at the Dollar Smile Theory in reality…
As you can see, due to the global pandemic which has caused a lot of economies all over the world to suffer, the U.S. dollar is acting as a safe haven currency. All countries, including the U.S., aren’t doing so great.
But if the economies from the “rest of the world” (RoW) can improve and start to grow faster than the U.S. economy, then expect the U.S. dollar to weaken.
The key is relative economic growth. If growth from other countries is growing, but the U.S. economy is growing even faster, then the U.S. dollar will swing upward to the right side.
So will the Dollar Smile Theory hold true?
Only time will tell.
In any case, this is an important theory to keep in mind. Remember, all economies are cyclical. They strengthen, then they weaken, they strengthen, then they weaken and repeat.
The key part is determining which part of the cycle the U.S. economy is in and then comparing how it’s doing against the rest of the world (RoW).
A Strong Dollar’s Pros and Cons
When the dollar is strong, this makes traveling to other countries less expensive for Americans. And given how loud and obnoxious some American tourists can get, might not be a good thing.
Also, the price for imported goods into the U.S. also declines.
So for U.S. consumers, it’s great. Traveling to other countries and buying imported goods at home is cheaper.
But for non-U.S. consumers, it’s not so great. It’s more expensive to visit the U.S. (like going to Disney World). And they have to pay more for imported U.S. goods or commodities priced in USD (like oil).
Also, multinational corporations generate a sizeable percentage of their revenue outside the U.S. This means that they’ll experience a decline in profits when their revenue is exchanged from local currencies to U.S. dollars.
The Dollar Smile Summary
The Dollar Smile is a concept in currency trading and economics that explains how the U.S. dollar (USD) can appreciate in different economic conditions, forming a smile-shaped curve when plotted against the strength of the dollar.
Here’s a summary of the three distinct phases of the economic cycle, resembling a smile:
1. Economic Recession (Left Side of the Smile)
- Flight to Safety: During economic downturns or global financial crises, investors seek safe-haven assets. The USD is considered a safe-haven currency due to its stability and liquidity. As a result, demand for the dollar increases, causing it to appreciate.
- Capital Inflows: Investors move their capital into U.S. Treasury securities, which are seen as low-risk investments, further driving up the value of the dollar.
2. Economic Recovery (Bottom of the Smile)
- Weak Dollar: As the economy begins to recover but remains weak, the dollar typically depreciates. During this phase, risk appetite returns, and investors start seeking higher returns in riskier assets and markets outside the U.S.
- Monetary Policy: Central banks, including the Federal Reserve, may maintain low interest rates to stimulate economic growth, which can lead to a weaker dollar.
3. Strong Economic Growth (Right Side of the Smile)
- Economic Expansion: In a strong economic environment, the U.S. economy outperforms others, leading to increased investment in U.S. assets.
- Higher Interest Rates: The Federal Reserve may raise interest rates to prevent the economy from overheating, attracting more foreign capital and causing the dollar to appreciate.
- Positive Sentiment: Optimism about the U.S. economy leads to greater demand for the dollar.