The Dollar Smile Theory Explained

The US dollar is commonly regarded as the most crucial currency globally, but predicting its movements is frequently an exercise in uncertainty. Why would the dollar rise in good times and in times of recession, but significantly decline in times of only "okay" for the world economy?

This is the mystery that the Dollar Smile Theory attempts to explain. By understanding the dollar as a smile that has three parts, or phases, traders, economists, and investors can better contextualize the dollar at different points in the economic cycle. Let's break this theory down piece by piece, so you will always view the dollar differently.

What Is the Dollar Smile Theory?

The Dollar Smile Theory is a framework explaining how the US dollar typically behaves during each of three specific economic experiences, and the "smile" is derived from how this framework appears graphically when you plot these three experiences.

The dollar is on a "smile" when it is either powerful (during a crisis or robust growth) or very weak (during moderate global growth). Stephen Jen of Morgan Stanley developed this methodology and has become a popular approach for analyzing dollar appreciation/depreciation.

The Three Phases of the Dollar Smile

1. The Left Side: Crisis and Risk Aversion

The left side of the "smile" refers to a time when the global economy is in bad shape. The financial markets are imbalanced and volatile, with risk appetite at an all-time high, and investors are flocking to safe assets. The dollar generally appreciates under these conditions.

When things are at their worst, or a limited period of panic, and everyone goes into "how to be safe" mode, the US dollar does very well (period). In these situations, you could have every other primary currency be "down," and the US dollar could still be "up." The dollar appreciates because it is the world's preeminent reserve and safe-haven currency.

Key factors:

• All kinds of global crises (financial, geopolitical, or natural disasters)

• Capital flight from the emerging markets to US Treasuries

• A flight to liquidity and safety

2. The Middle: Moderate Growth and Stability

In the mid-section of the curve, global growth is steady, but not extraordinary. Markets are calm, risk-on conditions are favourable, and investors are comfortable allocating money to higher-yielding investments outside the U.S. During this period, the dollar tends to weaken as capital flows out to currencies and assets that offer better returns.

Key factors:

• Steady growth in emerging and developed economies

• Low volatility in global financial markets

• Carry trades and investment diversification from the US.

3. The Right-Hand Side: Strong US Growth and Higher Yields

On the right-hand side of the curve, the US economy is experiencing a period of growth. Interest rates are rising, growth is robust, and investors are drawn to US assets. Again, the dollar strengthens, not necessarily because of fear, but because of opportunity.

Key factors:

• Higher US interest rates compared to the investment universe

• Healthy GDP growth and corporate earnings results

• Increases into US equities and bonds

Why the "Smile" Shape?

The dollar smile depicts two contrasting but influential forces:

• Fear: What emerges in periods of adversity, during periods of economic panic or turmoil (aka crises), investors race into dollars, causing the DXY to rise sharply (this is an excellent example of the left side of the smile)

• Opportunity: What emerges in times of strong growth of the US economy, but the significant opportunity of attractive returns from US dollar assets, and in this instance, the DXY would rise again (this would be the right side of the smile).

• Complacency: Middle area of the curve where nothing outstanding is happening, and both complicit sides lead the dollar to be weaker.

Historical examples of the dollar smile

(2008) The financial crisis

During the global financial crisis, a massive level of panic swept the markets as richly priced equities plummeted in value. Investors rushed to get dollars, pushing the DXY sharply higher. A perfect example of the left side of the smile

(2010- 2011) In the early stages of recovery

As the global economy began to recover and stabilize, investors poured money into emerging markets. At this point, the dollar weakens, and people will lament how things look 'better' outside of the US dollar, but you quickly will run out of places to invest overseas. You will also lose interest in making those investments beyond those with higher yields overseas, and what attracted you to the overseas market.

(2019-2021) As a result of the 2016 tax reform

Even after we raised rates and approached a breaking point with growth, the DXY was strong again because of tax reform and relatively reasonable growth and attractive returns, which create means to keep the DXY up and positive.

Strengths of the dollar smile

• Simple to use and completely understandable in general

• Historical behaviour fits the cycles in the dollar smile.

• Manage the time frames of shifts in weaknesses in dollars. 

Consider weaknesses

The dollar smile may serve a useful purpose, but it also has its faults. - Not always predictable: Real-world markets are not always predictable, and the dollar smile does not capture all aspects of this behaviour.

- Doesn't account for structural changes: It does not capture the influence of emerging markets or currencies such as the Chinese yuan.

- Timing challenge: Even if the theory is valid, when the dollar will transition from one phase to another is difficult to know.

How Traders and Investors Use the Theory

- Forex traders look to it as a long-term indicator of where the dollar might go and can help inform longer-term trading or research decisions.

- Portfolio managers consider it when building more diversified allocation plans across global asset classes.

- Commodity traders use it to gauge the weakness or strength of the dollar, or may influence the price of commodities.

Tips for Using the Dollar Smile Theory

1. Attach the US economic data carefully.  Good jobs numbers, inflation, and GDP growth would indicate strong dollar movement on the right side of and into the right 'smile'.

2. Monitor global fears or risks.  Political instability or financial distress can push the dollar to the left side of the curve. 

3. Don't use the dollar smile alone. See it in conjunction with a technical price analysis, interest rate movement, and overall considerations from the central bank.

4.  e flexible.  The dollar is also unpredictable in its own right, and all scenarios can be adjusted accordingly.

Conclusion

The Dollar Smile Theory presents an intriguing and engaging perspective on why the US dollar may experience strength in times of crisis, but only when the US economy is robust, albeit not during periods of economic weakness. While no theory is ever perfect, the "smile" provides traders and investors with an opportunity to intuitively correlate market conditions and/or environment with dollar behaviour.

For those exploring the complex world of forex or global investing, the Dollar Smile suggestion is a strong guide that reminds you that the dollar is not simply unidimensional; it is both feared and sought after as an opportunity.  Understanding where you are on the "smile" will hopefully assist you in positioning yourself for the next move in the world's currency.