The Dollar Could Dazzle No Matter Where The US Economy Goes Next

The Dollar Could Dazzle No Matter Where The US Economy Goes Next
Stéphane Renevier, CFA

over 3 years ago3 mins

Mentioned in story

What’s going on here?

Imagine a Cheshire cat grinning ear to ear. Now imagine an investment with the same payoff profile; one which rises when the underlying economy is either very weak or very strong. Sound too good to be true? The reality – and its mundanity – may surprise you…

What does this mean?

The “dollar smile” is a well-known concept among finance professionals. First coined by a currency strategist at investment bank Morgan Stanley, the term refers to the US dollar’s tendency to rise in value when the American economy is performing particularly well – or particularly badly. Let me explain.

US dollar smile illustrated

When the US economy is expanding relatively rapidly compared to the rest of the world, overseas investors flock to buy American investments – priced in dollars – in a bid to grab a slice of the action. If growth gets too strong, the central bank has to hike interest rates to prevent the economy from overheating – which increases the rate of return on offer from said American investments. Both of these factors increase the demand for dollars and push the currency’s value higher. Between 2014-16, for example, the dollar strengthened by more than 20% for those exact reasons.

US Dollar Index

So what if the economy’s performing poorly? In such a “risk-averse” scenario, the US dollar also strengthens; it’s seen as a safe haven. Investors look to protect their portfolios by abandoning riskier emerging-market bets in favor of Old Faithful, where investments are generally more liquid and more stable. During this year’s March madness, for example, the dollar rose almost 10%.

Now astute readers will notice that we’ve only covered what happens at the smile’s extremities – and not what’s going on in the middle of the mouth. In this eventuality, US economic growth is neither too strong nor too weak. It’s an environment where global economies are moving in sync and investment volatility is contained. Here, investors tend to chase the higher returns available in emerging markets, with US investments – and the US dollar – experiencing international outflows. With positive vaccine news and super-supportive economic policies at play around the planet, this seems to be exactly what’s going on at the moment; the dollar’s value is down 10% since March, with many investors expecting the trend to continue.

Why should I care?

There’s nothing wrong with the dollar downfall thesis – except that everyone knows about it. From YouTube influencers to Goldman Sachs, everyone and their grandmother appears to be positioning for a world in which the dollar is worth less – as shown by the present popularity of related shorts:

US dollar short positions

So while the argument has merit, it might already be reflected in the dollar’s price. And as investing legend George Soros once said, “money is made by discounting the obvious and betting on the unexpected”. Any negative coronavirus-related surprises or disappointing data on global economic growth could threaten today’s fragile equilibrium and cause a dollar “short squeeze” – where those betting on the currency’s decline scramble to limit their losses and its value shoots up as a result.

That’s not to say that my long-term view on the dollar is necessarily positive; rather, with the dollar smile on our side, betting on its rise simply seems the most attractive trade at this point. To hear my detailed thoughts on how you could make this happen , tap 🎧 and access the audio version of this Insight…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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