The Dollar Smile Theory is an important concept for traders working with USD pairs. Have you ever thought about the fact that it seems like the U.S. Dollar rises both in times of economic boom and in times when the economy is in shambles? This is because of the unique position of the USD as the world’s reserve currency. It can rise regardless of how the overall economy is doing.
One way to think about this is to pretend that there are two types of U.S. Dollar:
- The domestic U.S. dollar – This one rises and falls with the U.S. economy just like any other currency would.
- The international U.S. dollar – This one is linked to the U.S. dollar used for international trade and to fund safe investments like U.S. Treasuries and Bonds.
The international U.S. dollar would rise when the markets are volatile. However, the domestic U.S. dollar would rise when the markets are strong in the United States.
There aren’t actually two different types of U.S. dollars floating around out there, but it is useful to think of it this way to understand why the U.S. dollar does what it does in various market conditions.
What is the Dollar Smile Theory?
This is a funny-sounding one, isn’t it? That’s how it goes in the forex market sometimes. The Dollar Smile Theory was created by Stephen Jen, a former economist for both the International Monetary Fund and Morgan Stanley. The Dollar Smile Theory assumes that the U.S. Dollar tends to strengthen when the U.S. economy is extremely strong or extremely weak. It is only when the U.S. economy goes into a holding pattern of sorts that the dollar loses some of its strength and value.
Explaining the Dollar Smile Theory
The theory relies on two major assumptions:
- If the U.S. economy significantly outperforms economies around the world, then the U.S. dollar will also strengthen along with it.
- If markets are chaotic and volatile, then the rush to safety pushes the U.S. dollar higher as well. In this case, traders are switching to a “risk-off” mentality when they purchase more U.S. dollars as a safe haven bet.
In this theory, there are three main scenarios for how things work out for the USD.
Scenario 1: USD Increases Due to Fear
The U.S. dollar may increase because all of the other market participants are worried about other investments available to them out in the world. They start to see other markets as too risky, and they begin to push their money into the U.S. dollar as it is seen as a safe haven when other markets are shaky.
All of that extra investment money coming into the USD pushes it higher than it otherwise would be.
Scenario 2: USD Decreases Due to Weak Internal Economy
The U.S. dollar may decrease due to a weak domestic economy. It is not completely immune from being shaken up when the domestic economy (aka the economy in the United States) takes a tumble. It is possible that increased interest rates in the United States might also take the dollar down a peg.
To look at how the USD might do during a period of economic uncertainty in the United States, it is important to think about how the U.S. economy is doing relative to the rest of the world. If the U.S. economy is particularly weak compared to the rest of the world, then the Dollar Smile Theory suggests that the USD will decline in value. However, it is all about that relative balance between the U.S. economy and other economies around the world.
Scenario 3: USD Increases Because of Economic Growth
When the U.S. economy catches on fire and is like a rocket ship to space, then the U.S. Dollar is also likely to increase in value. There is seemingly nothing that can hold it back in this scenario. All of the factors are shaping up just right for the USD to go much higher against other currencies. People in the United States are experiencing growth in their domestic economy, and that fuels more strength in the USD. This is the second scenario in which the USD strengthens in the Forex market.
The question that so many people have when it comes to the Dollar Smile Theory is if it holds in real market conditions. Right now, only time will tell. There are instances when it has seemingly panned out exactly as predicted, but it is not a guarantee that this will continue in the future. Theories about the market tend to come and go, but it will be interesting to see how this one continues to play out under various market conditions. It is simply not clear enough at this time to say with complete confidence which way it will ultimately go.
Is a Strong Dollar a Pro or a Con?
It sounds like a strong dollar would always be a positive thing, but that isn’t necessarily true. There are pros and cons to a strong dollar, and it is worthwhile to examine what those are.
The price of imports to the U.S. is decreased when the dollar is strong. It also makes international travel less expensive for Americans traveling abroad.
When the dollar is strong, U.S. consumers get the good end of the deal. They can save money on the things that they buy, including the things that they buy that are imported.
Non-US consumers have a rougher time of it when the dollar rises in value because they have to pay more for things in the United States. It means that people wanting to visit the country pay more than they otherwise would. Thus, there is a trade-off between who wins and who loses when it comes to the rising US dollar. The world has to adjust its expectations about how much it will pay for certain goods and services.
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