Everything You Need to Know about the Dollar Smile

Everything You Need to Know about the Dollar Smile

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The foreign exchange market is a unique space where currencies are traded against one another. Boasting a long and colourful history, traders and investors use a myriad of techniques and strategies to navigate and invest in the Forex market, ranging from simple manual systems to complex algorithms. 

One intriguing theory that attempts to describe the behaviour of the US dollar (USD), the world’s most-traded currency (according to the Bank for International Settlements [BIS]), is the Dollar Smile Theory.

The Dollar Smile Theory is Born

Coined by Stephen Jen in 2001 while working at Morgan Stanley, the Dollar Smile Theory posits that the USD benefits in good times and bad. Jen, who holds a PhD in Economics and is now a hedge fund manager, recognised a recurring pattern in the performance of the USD; the currency would appreciate in times of strong US economic growth (this can be referred to as a risk-on scenario in which riskier assets tend to outperform) and equally, when a US or global recession takes hold (a risk-off scenario that can often trigger safe-haven dollar buying). While everything in between should see a weaker dollar.

Interpreting the Dollar Smile Curves

Right Side of the Dollar Smile:

The right side of the Dollar Smile’s curve explains that when real GDP growth (Gross Domestic Product) increases, this usually leads to the US Federal Reserve tightening policy (increasing the Fed funds target range) and the USD appreciating. This is a reasonable assumption and one that would not raise too many eyebrows. If an economy is outperforming and asset prices – like stocks and bonds – are rallying, foreign investment will subsequently increase and create demand for the USD.

Left Side of the Dollar Smile:

The left side of the Dollar Smile’s curve suggests that a US or global recession can equally lift the USD. On the surface, this may seem counterintuitive. Why would the USD rally at a time when stocks and bonds trade lower and risk aversion becomes the dominant sentiment? It happens because when the US enters a recessionary period, markets and economists fear that the global economy will likely follow suit. We must understand that the USD is perceived as a safe-haven currency, one which is bought (as investors look to US Treasuries, for example) in times of market uncertainty, such as recession. The US, with its reputation for global dominance and economic/political stability, becomes a prime destination. This ‘flight to safety’ fuels safe-haven buying in the USD, fuelling a rally in the major currency. One such example of this was the sharp appreciation of the currency during the 2008 financial crisis.

You may have heard the phrase ‘When America Sneezes, the rest of the World catches a Cold’, meaning that the world is more globally connected than it has ever been, and if problems arise in the world’s biggest economy, then this can filter through to the rest of the world. 

Central Part of the Dollar Smile:

The central part of the Dollar Smile’s curve is a point at which the US economy is just ‘muddling through’ at a time when global growth is doing reasonably well. You can think of the trough of the smile as the ‘mediocre middle ground’ and the US economy is neither displaying outperformance nor underperformance against its peers. 

A scenario like this may naturally prompt investors to seek alternative investment opportunities in foreign markets, thus selling dollar-denominated assets and weighing on the USD. 

Where Are We on the Curve Now?

As you would expect, there are many moving parts behind price movement in the foreign exchange market, including central bank monetary policy and inflation, as well as fiscal policy and politics. While the Dollar Smile Theory is a helpful heuristic, it is recommended to keep an open mind when estimating the value of the US dollar.

The Right Side of the Dollar Smile?

According to the US Dollar Index, the US dollar is up +3.1% year to date as of writing. Given the current state of the US economy, we are likely to be in the middle of the right side of the smile. 

On the growth front, US real GDP (Gross Domestic Product) slowed to an annualised pace of 1.6% in Q1 of this year, according to the advance estimate provided by the Bureau of Economic Analysis, down from 3.4% in Q4 of 2023. However, it is important to remember that the US economy has remained remarkably resilient compared to its global peers, with many developed economies stagnating. 

Nevertheless, US economic activity has been affected by high interest rates, which look set to remain in restrictive territory for the time being (given persistent inflationary pressures). This should keep the dollar bid for the time being. 

The Left Side of the Dollar Smile?

As communicated above, the US economy remains resilient against other advanced economies, albeit slowing. At this point, we are not in a global recession, but economic growth is stationary in Europe. Should the US fall into recession, global economies could soon follow suit, thus presenting a scenario where the left side of the Dollar Smile comes into play and shows USD appreciation.

Another consideration is that numerous geopolitical factors are at play right now, which can boost the USD's safe-haven appeal and place us more on the left side of the Dollar Smile’s curve. 

Dollar Smile Theory FAQs

1. What is the Dollar Smile Theory?

The Dollar Smile Theory posits that the USD should strengthen when the US economy is strong and when it is weak. The Dollar Smile's ‘trough’ indicates a point where the US economy is neither displaying outperformance nor underperformance against its peers.

2. Can the Dollar Smile Theory be used to forecast the USD?

Many factors drive the US dollar’s value; the Dollar Smile Theory is just one component. Before investing in the USD, it is important to consider all variables, including monetary policy, inflation and employment.

3. Where are we on the Dollar Smile Curve?

With US economic activity contracting but still higher than other global economies, we appear to be in the middle of the right side of the Dollar Smile.