Ever wonder why the U.S. dollar strengthens in bad times and good times? Well, others have similar doubts. In fact, a smart brother who used to work at Morgan Stanley has come up with a theory to explain this phenomenon.
Ren Yongli , a former currency strategist and economist, proposed a theory and named it the “dollar smile theory.” His theory describes three scenarios that guide the dollar’s behavior. Below is a simple illustrated illustration.
Scenario 1: USD appreciates due to risk aversion . The first part of the smile shows that the dollar benefits from risk aversion. Risk aversion has led investors to flee to “safe haven” currencies such as the dollar and yen . Investors are hesitant to keep chasing risky assets as they see the global economy as volatile, increasing their willingness to buy the less risky dollar and ignoring the state of the U.S. economy.
Scenario 2: The dollar falls to a new low. The bottom of the smiley face reflects the lacklustre performance of the dollar, which is due to the weakening of the fundamental conditions of the US economy . The possibility of a rate cut would also depreciate the dollar . This caused the market to start avoiding the dollar. Regarding the dollar, their motto changed to “Sell! Sell! Sell!”
Scenario 3: The dollar appreciates in response to economic growth. Finally, the smile shows, as the U.S. economy finally sees a ray of hope. Optimism has risen, the economy has turned for the better, and investors’ confidence in the dollar has begun to rise. In other words, the dollar started to appreciate as the U.S. economy enjoyed a stronger rate of GDP growth, as well as rising interest rate expectations.
When the 2007 financial crisis hit, the theory appeared to be working. Remember when the U.S. dollar strengthened substantially at the height of the global recession? This is the first stage.
When the market finally bottomed out in March 2009, all of a sudden, investors turned to high-yielding currencies, which earned the dollar the title of “worst-performing currency” in 2009.
So does the dollar smile theory hold?
Time will tell.
Regardless, this is a theory to keep in mind. Remember, the economy is cyclical.
The key is to figure out where the economy is in the cycle.
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