{"id":37918,"date":"2023-07-19T20:19:38","date_gmt":"2023-07-20T00:19:38","guid":{"rendered":"https:\/\/ifintechworld.com\/markets\/dollar-smile-theory-says-the-currency-will-weaken-further-but-some-believe-the-framework-could-use-an-update\/"},"modified":"2023-07-19T20:19:40","modified_gmt":"2023-07-20T00:19:40","slug":"dollar-smile-theory-says-the-currency-will-weaken-further-but-some-believe-the-framework-could-use-an-update","status":"publish","type":"post","link":"https:\/\/ifintechworld.com\/?p=37918","title":{"rendered":"\u2018Dollar smile\u2019 theory says the currency will weaken further, but some believe the framework could use an update"},"content":{"rendered":"
A widely used framework that has proved successful at anticipating cycles of U.S. dollar strength and weakness suggests the world\u2019s reserve currency will likely weaken further. <\/p>\n
But some Wall Street professionals are concerned that the theory, known as the \u201cdollar smile,\u201d might be in need of an update. <\/p>\n
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What\u2019s the \u2018dollar smile\u2019?<\/h2>\n
Initially developed in 2001, the \u201cdollar smile\u201d framework is a rarity in the world of finance: it\u2019s both relatively simple, and has a strong track record of success. <\/p>\n
Here\u2019s how it works, according to a group of currency analysts including the theory\u2019s creator, Stephen Jen, CEO and co-CIO of Eurizon SLJ Asset Management. There are two scenarios that typically coincide with U.S. dollar strength: when global economic growth is contracting, or when the U.S. economy is doing so well that it\u2019s leaving other countries in the dust. These scenarios represent the opposite extremes of the dollar \u201csmile,\u201d as the image below, furnished by Eurizon SLJ, shows. <\/p>\n
<\/p>\n<\/p>\n<\/figure><\/div>\n
On the other hand, the U.S. dollar tends to weaken when the U.S. economy is doing relatively well, but not outstandingly so. <\/p>\n
Perhaps the most memorable example of the theory occurred in the aftermath of the global financial crisis in 2008, when the dollar soared briefly even though the crisis originated in the U.S.<\/p>\n
Looking ahead, the dollar\u2019s weakness in the last six months is consistent with the \u201csoft landing\u201d scenario for the U.S. economy that Jen and others believe has already arrived, meaning that the rise in interest rates engineered by the Federal Reserve in the past year has led to a slowdown in economic growth without causing a recession. <\/p>\n
\u201cThe dollar will weaken further,\u201d Jen said in commentary emailed to MarketWatch.<\/p>\n
\u201cAs the U.S. economy decelerates and other economies settle down after exiting from the unique pandemic shock, it is likely that the major economies will cluster together in terms of their economic growth rates, like the peloton in the Tour de France, with no clear \u2018winner.\u2019\u00a0 That is the classic setting for the \u2018trough\u2019 of the Dollar Smile.\u201d<\/p>\n
How has it worked? <\/h2>\n
More examples of the utility of the dollar smile theory abound over the past decade.<\/p>\n
Between July 2014 and December 2016, the greenback advanced against the euro, Japanese yen and other rivals as the U.S. economy\u2019s recovery in the wake of the 2008 financial crisis outpaced its rivals. Ultimately, the ICE U.S. Dollar Index \n DXY, \n -0.04%<\/bg-quote>,<\/span> \n a closely watched gauge of the dollar\u2019s value compared with other major currencies, rose nearly 30% from trough to peak. <\/p>\n
In 2022, the dollar surged amid a global rush for safety as stocks and bonds careened lower in the wake of the coronavirus pandemic. At the time, the Federal Reserve was raising interest rates at the fastest rate since the 1980s to combat inflation resulting from the pandemic while other central banks including the Bank of England and European Central Bank pursued rate hikes of their own. <\/p>\n
At its peak, the dollar index traded at its highest level in two decades in late September 2022. Despite paring its gains during the fourth quarter of last year as the S&P 500 stock index \n SPX, \n +0.24%<\/bg-quote> \n started to shake off some of its earlier weakness, the dollar index finished 2022 with a 7.9% gain, its best calendar-year performance since 2015, according to FactSet data.<\/p>\n
Whether the theory continues to hold is another matter. At a time when many market truisms appear to be coming unglued, some are wondering whether the dollar smile might also be ready for an update. <\/p>\n
For example, an inverted Treasury yield curve had a near-flawless decades-long track record of anticipating recessions, but increasingly economists expect that the recession it has been signaling for the better part of a year may never come to pass. <\/p>\n
See: <\/strong>Goldman chief economist sees reduced chance of recession and dismisses inverted-yield-curve worries<\/p>\n
Time for an update? <\/h2>\n
Rather than abandoning the dollar smile framework entirely, some top Wall Street currency analysts believe some revisions might be in order. <\/p>\n
Jens Nordvig, founder of Exante Data and formerly a currency strategist at Nomura Securities, told MarketWatch during a phone interview that the dollar smile may not be well-equipped to incorporate the impact of inflation, simply because it has never confronted it before. <\/p>\n
\u201cThe smile is a two-dimensional thing related to growth and the dollar,\u201d Nordvig said. \u201cBut inflation is potentially the most important dimension now, and I think that can mess up the smile a bit.\u201d <\/p>\n
Just look at how the dollar reacted to last week\u2019s U.S. consumer price inflation report for June, which showed that inflation is ebbing more quickly than economists polled by the Wall Street Journal had expected. The dollar index fell 2.3% last week, with the bulk of the drop following the inflation report. It marked the worst week for the greenback so far this year, and its 16th-worst week of the past 20 years, according to Dow Jones Market Data. <\/p>\n
U.S. consumer prices rose 0.2% in June, undershooting expectations for 0.3% growth from economists polled by the Wall Street Journal.<\/p>\n
Others have proposed tweaking the shape of the smile to account for a more complicated global macro environment in the wake of the COVID-19 pandemic. <\/p>\n
Deutsche Bank strategist Alan Ruskin recently proposed that the smile might be morphing into a \u201csmirk.\u201d He proposed another scenario, where global economic growth moderates, but a punishing recession is avoided. In his view, such an environment \u2014 not completely risk-on nor risk-off \u2014 could lead to more placid trading in the world\u2019s largest currencies. <\/p>\n
<\/p>\n<\/p>\n<\/figure><\/div>\n
Steve Englander, global head of G-10 currency research at Standard Chartered, has been bearish on the U.S. dollar all year. The thrust of his research has focused on whether the dollar \u201csmile\u201d resembles a \u201cMona Lisa smile\u201d where there\u2019s a broader range of scenarios in the middle that would lead to dollar weakness, or a \u201cjoker\u201d smile, which would in theory see the dollar bounce back more quickly if the U.S. economy holds up. <\/p>\n
<\/p>\n<\/p>\n<\/figure><\/div>\n
\u201cWe\u2019re seeing that slowing U.S. growth is actually risk positive,\u201d Englander told MarketWatch during a phone interview. \u201cIf there\u2019s a recession it\u2019s going to be a 1% [contraction] recession, not a 5% [contraction].\u201d <\/p>\n
Eurizon\u2019s Jen agreed that inflation could complicate the dollar smile\u2019s predictive ability. He said that he\u2019s ready to make changes \u2014 or perhaps scrap the framework entirely, if necessary \u2014 once all the evidence is in. <\/p>\n
\u201cWhen the macro settings change, we need to form a judgement on (i) whether to use the DS framework at all, or (ii) how to modify the simple DS framework to help us think about the world,\u201d Jens told MarketWatch. <\/p>\n
Whatever happens to the dollar, the implications for global markets could stretch far beyond the U.S. A weaker dollar often coincides with higher prices for U.S. stocks, and often international equities as well.<\/p>\n
See more<\/strong>: Why stocks could get a boost from a falling U.S. dollar<\/p>\n
The dollar is on track to decline again this week, with the dollar index down 0.3% so far to trade at 99.94, roughly its lowest level since early April 2022. <\/p>\n<\/p><\/div>\n