“The Dollar Smile”: Why Does the Dollar Strengthen in Both Good and Bad Times?

Have you ever wondered why the US dollar strengthens both during crises and when the economy is booming?

Normally, currencies depreciate when a country’s economic outlook worsens, but the US dollar has a unique global role that makes it an exception – so even when the US economy isn’t doing great, the dollar can still appreciate.

To understand why this happens, it’s useful to think of the US dollar as having two “types”:

1. Domestic Dollar – behaves like any other currency. It depends on economic prospects and the expected return on investments in the US.
2. International Dollar – used as the main currency in global trade and to purchase US government bonds, which are sought after for their safety.

It’s this “international” dollar that strengthens during periods of market uncertainty and slowing global growth.

When a shock occurs – whether from the US or abroad – and it’s serious enough to scare investors and traders into pulling out of markets, the US dollar usually strengthens.

In fact, one smart guy who used to work at Morgan Stanley came up with a theory that explains this phenomenon.

What is the “Dollar Smile Theory”?

Stephen Jen, a former economist at the International Monetary Fund and Morgan Stanley, and now the head of hedge fund and consulting firm Eurizon SLJ Capital in London, formulated and named the “Dollar Smile Theory.”

Explaining the Dollar Smile Theory

The theory says that the US dollar tends to strengthen against other currencies in two extreme scenarios:

1. When the US economy significantly outperforms the rest of the world – the dollar strengthens due to better investment prospects.
2. When global financial markets are in turmoil or crashing – investors seek safety, and the dollar is seen as the ultimate “safe haven,” leading to a rush to buy USD and drive up its value.

The theory presents three main scenarios that shape the behavior of the US dollar – forming something like a smile when plotted on a graph:

• Strong dollar with strong economy (left side of the smile),
• Weaker dollar during stable or average conditions (bottom of the smile),
• And strong dollar again during global uncertainty or recession (right side of the smile).

Scenario #1: Dollar Strengthens Due to Risk Aversion

Dollar Smile Theory: Panic

The first part of the smile shows how the US dollar benefits from risk aversion – this drives investors toward “safe havens” like the US dollar and Japanese yen.

When investors perceive the global economy as unstable, they avoid risky assets and prefer to place their money in safer instruments like US Treasuries, regardless of the current state of the US economy.

But to buy Treasuries, you need USD – so increasing demand for dollars leads to a stronger US dollar.

Scenario #2: Dollar Weakens Due to a Weak Economy

Dollar Smile Theory: The Bull Falls Off a Cliff

At the bottom of the smile, we see the dollar weaken as the US economy struggles with poor economic indicators.

Expectations of interest rate cuts also weigh on the dollar. (However, if other countries are also expected to cut rates, the effect may be muted – what matters is the comparison between expectations in different economies.)

This leads markets to pull away from the dollar – the motto becomes: “Sell! Sell! Sell!”

Another factor is the relative economic performance between the US and other countries. Even if the US isn’t in a recession, if its growth is weaker than others, investors may prefer to sell dollars and buy the currency of the stronger-performing country.

Imagine you own an NBA team and your star is Reggie Miller. Suddenly, a healthy Michael Jordan becomes available. Of course, you’d swap Miller for Jordan – because he’s the better player right now.

It’s not that Reggie is weak, but there’s a better option available. And if Jordan suffers a serious injury and Miller becomes available again – you know what to do:
Switch from “Air Jordan” back to “Miller Time.” It’s all about comparisons.

Scenario #3: Dollar Strengthens Due to Economic Growth

Dollar Smile Theory: Bull Market

Finally, the smile begins to rise again – the US dollar strengthens as the US economy starts to recover.

When optimism and signs of economic rebound appear, sentiment toward the dollar improves.

In other words, the dollar starts gaining strength because:

• GDP is rising,
• Expectations for higher interest rates in the US (relative to other countries) are increasing.

As we can see, due to the global pandemic that caused severe economic difficulties around the world, the US dollar behaved like a safe-haven currency. All countries, including the US, didn’t perform particularly well.

But if the economies of the so-called “Rest of the World” (RoW) begin to recover and their growth outpaces that of the US, we can expect the dollar to weaken.

The key here is relative economic growth. If other countries are growing, but the US is growing even faster, then the dollar will strengthen and move to the right side of the “smile.”

Will the Dollar Smile Theory hold true?

Only time will tell.

In any case, it’s an important theory worth remembering. Don’t forget, all economies are cyclical – they strengthen, then weaken, then strengthen again… and so on.

The key is to understand where the US economy is in the cycle, and then compare it to the state of the rest of the world.

Pros and Cons of a Strong Dollar

When the dollar is strong:

• Traveling abroad becomes cheaper for Americans.
  (And considering how loud and obnoxious some American tourists can be, this may not be good news.)
• Imported goods in the US become cheaper.
  For American consumers, that’s great – both travel and foreign purchases become more affordable.

But for people outside the US, it’s not so great:

• Visiting the US (like going to Disneyland) becomes more expensive.
• They have to pay more for American goods or commodities priced in dollars (like oil).

Also, multinational corporations that generate significant revenue outside the US suffer when those earnings have to be converted back into US dollars – this reduces their profits.

Summary: The Dollar Smile Theory

The Dollar Smile Theory is a concept in currency trading and economics that explains how the dollar can appreciate under different economic conditions, forming a smile-shaped curve when plotted against its strength.

The Three Main Phases:

1. Economic Recession (Left Side of the Smile)

• Flight to safety: During downturns or global crises, investors seek “safe havens” like the USD – the dollar appreciates.
• Capital flows: Funds are directed towards US government bonds, which are considered low-risk.

2. Economic Recovery (Bottom of the Smile)

• Weak dollar: The economy is recovering, but it’s still weak. Investors are looking for higher returns in other markets.
• Monetary policy: The Federal Reserve may keep interest rates low, which also weakens the dollar.

3. Economic Growth (Right Side of the Smile)

• Economic expansion: The US economy outperforms others, leading to more investments in US assets.
• Higher interest rates: The Fed may raise interest rates to prevent overheating – this attracts more capital.
• Positive expectations: Increased optimism leads to growing demand for dollars.