Currencies tend to decline when their country’s domestic economic outlook worsens, but the US dollar’s unique global position distinguishes it, so even when the US economy isn’t doing well, the currency may rise.
To understand why this is the case, imagine there are two “types” of US currencies.
- 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.
What is Dollar Smile Theory?
The “dollar smile theory” is a term used to describe a graphical representation of the U.S. dollar’s value against other currencies. The theory suggests that the shape of the graph resembles a smiley face, with the ends of the smile representing periods of strength in the dollar and the middle of the smile representing a period of weakness.
According to the theory, the dollar tends to strengthen during times of global economic growth and times of uncertainty, such as during financial crises. This is because investors tend to seek the safety of the U.S. dollar during these periods. On the other hand, the dollar tends to weaken during periods of moderate economic growth and expansion, as investors move away from the safe-haven currency and towards riskier investments.
The “dollar smile theory” is a useful tool for forex traders who are looking to understand the movements of the U.S. dollar and its impact on the global economy. However, it is important to note that the theory is not a perfect predictor of market behavior and should be used in conjunction with other analytical tools and market data.
In short, 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:
1. 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.
2. 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.
Scenario #1: USD Strengthens Due to Risk Aversion
The first half of the smile depicts the US dollar benefiting from risk aversion, which causes investors to flock to “safe haven” currencies such as the US dollar and Japanese yen.
Because investors believe the global economic situation is shaky, they are hesitant to seek risky assets and would rather accumulate “safe” assets such as US government debt (“US Treasuries”) regardless of the state of the US economy.
However, in order to purchase US Treasuries, you must have USD, so the increased desire for USD (to purchase US Treasuries) causes the US dollar to strengthen.
Scenario #2: USD Weakens to New Low Due to Weak Economy
The dollar has reached a fresh low.
The bottom half of the smile represents the Greenback’s poor performance as the US economy struggles with weak economic fundamentals.
The prospect of interest rate cuts also weighs on the US currency. (However, if other countries are also anticipated to reduce interest rates, this may be less of a factor because it all comes down to expectations of the future direction of interest rate differentials.)
Another consideration is the relative economic performance of the United States and other nations. The US economy is not necessarily bad, but if its economic growth is weaker than that of other countries, investors will prefer to sell US dollars and purchase the currency of the stronger economy.
Scenario #3: USD Strengthens Due to Economic Growth
Economic development causes the dollar to rise in value.
Finally, a grin appears as the US economy sees the light at the end of the darkness.
As optimism grows and signs of economic recovery emerge, so does sentiment toward the US currency.
In other words, the US dollar starts to strengthen as the US economy experiences stronger GDP growth and expectations of interest rate hikes rise. (relative to other countries).
Let’s look at the Dollar Smile Theory in action.
As you can see, the US dollar is acting as a safe haven currency as a result of the global pandemic, which has harmed many economies around the globe. All nations, including the United States, are struggling.
However, if the economies of the “rest of the world” (RoW) improve and begin to expand faster than the US economy, the US dollar will weaken.
The important word here is relative economic growth. If growth in other nations is increasing but the US economy is growing faster, the US dollar will swing to the right.
A Strong Dollar’s Pros and Cons
In addition, the cost of imported products into the United States is falling.
So it’s fantastic for US customers. It is less expensive to travel to other countries and purchase imported goods at home.
But it’s not so good for non-US customers. It is more expensive to travel the United States. (like going to Disney World). Furthermore, they must spend more for imported US goods or commodities priced in USD. (like oil).
Furthermore, multinational corporations make a sizable portion of their revenue outside of the United States. This means that when their income is converted from local currencies to US dollars, their profits will fall.