DOLLAR SMILE THEORY
In the early 2000s, economist Stephen Jen developed a theory to explain how the dollar performed in different economic conditions. The dollar smile theory states that the dollar strengthens at both extremes of economic performance and falls in the middle. This means that it will rally when the US economy is at its weakest and when it is performing well. Moreover, since it falls in the middle of these extremes, it forms the shape of a smile.
To better understand the dollar smile theory, let us look at the three economic states that form the pattern.
ECONOMIC WEAKNESS
In times of extreme weakness in the US economy and global markets, the dollar benefits from safe-haven inflows. When nearly all economies perform poorly, investors panic and run for safe-haven assets like gold and US Treasuries.
As more people buy US Treasuries, they increase demand for the dollar, which rallies. This creates the first part of the smile, where the greenback surges in extremely poor economic times.
MILD ECONOMIC WEAKNESS
After the initial economic decline, investors stop panicking and instead focus on the fundamentals. Economic data, including GDP and employment figures, can start weighing on the greenback. Here, the dollar drops, especially if the US economy is performing poorly compared to other economies. Investors buy more into economies performing better than the US, dumping the dollar.
At the same time, the US central bank might start lowering interest rates to revive growth. This also weakens the dollar as US assets slowly begin to yield less. At this point, investors turn to better yields or non-yielding safe-haven assets like gold. Consequently, the dollar dips, forming the middle part of the smile.
ECONOMIC STRENGTH
After the period of weakness, monetary policy adjustments start reviving growth. Lower borrowing costs allow businesses to recover, attracting investors from outside. As growth and inflation pick up, the US central bank starts increasing borrowing costs, boosting the dollar. Demand for government debt soars due to the higher yields.
The dollar will strengthen, primarily when the US economy performs better than other economies. At this time, the dollar recovers gradually, forming the last part of the smile.
PRACTICAL ILLUSTRATION
Above is an excellent example of this theory in action. The dollar index surged during the start of the COVID-19 pandemic in early 2020. When the disease first came, there were global lockdowns, which hurt economic growth. The initial panic had investors rushing to the dollar, which rose sharply as a result.
However, the trend soon changed when the realities of the disease started showing in economic reports. Fundamentals pointed to weaker economic growth and loss of employment for most individuals. At this time, the Fed lowered interest rates to near zero to spur economic growth and inflation.
Soon after, the economy started recovering and demand for the dollar rose gradually. At the same time, growth and inflation picked up. This prompted the Fed to start hiking interest rates around March 2022 to control the high inflation. As a result, the dollar soared, completing the smile pattern.
Sources:
http://forexsource.net/
