The Dollar Smile hypothesis was created over 20 years ago by Stephen Jen at Morgan Stanley. Simply put, when the US economy significantly under or outperforms the rest of its peers, the dollar tends to be strong and increase in value compared to other currencies. This means that, if there is a hard landing or even a crash in the US economy, the dollar could paradoxically rally. The reference to the “smile”, is because the dollar occupies a hegemonic position as a reserve international safe-haven currency that remains central to capital market transactions. Stated differently, the US dollar can strengthen due to global recession and risk aversion or strong US economic growth relative to the rest of the world.
As we have often emphasized, currencies are complex. They are frequently used as a policy tool and can diverge from “fundamental” drivers such as growth, inflation, interest rates, and external positions for an extended period. Currencies are always a relative price. Hence the fundamentals need to be viewed in relative terms. For the US, the additional consideration is the reserve currency status as we noted above.
In the current episode, the dollar index peaked in late 2022 when the Fed policy cycle was well advanced and peak hawkish beliefs on the path of future short rates. At the time, the prevailing bias estimated that the terminal Fed funds rate had increased to around 5.70% from a combination of resilient macro conditions, tight labour market, strong fiscal impulse, and sticky core service sector inflation. These factors also contributed to the head fakes and big flip in consensus rate expectations and the dollar in both directions over the past two years (chart 1).
Chart 1
As we noted earlier this week, our sense is that the recent macro news flow is no longer a recession head fake or transitory growth fear. The US labour market has turned down and hard. As a result, the decline in US short term rates has undermined the dollar. However, we would note, consistent with the dollar smile thesis that the dollar could rally if investors start to anticipate a sharper deterioration in global growth. In turn, that would likely contribute to de-leveraging and self-reinforcing risk aversion.
Commodity currencies are particularly sensitive to risk perceptions as the terms of trade (export prices relative to import prices) are correlated to global growth and drive national income. The Australian dollar has underperformed the strength in the terms of trade since 2021 (chart 2). This might be explained by the Reserve Bank maintaining lower rates relative to the US Federal Reserve and the anaemic cyclical momentum in China (Australia’s largest trading partner).
Chart 2
The terms of trade were supported by elevated iron ore prices, that appear unsustainable given demand in China, excess inventory, and weakness in the broader commodity complex. Further policy easing in China appears either unlikely or insufficient to boost aggregate demand. Cyclical currencies, particularly commodity currencies could be vulnerable to a renewed phase of US dollar strength for the wrong reasons, global growth fear and de-leveraging. Look out for the smiling assassin (the USD).
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