Will Currency Markets ‘Smile’ on the US Dollar?
Posted 02-03-2010 at 09:32 AM by DailyFX
The US Dollar is likely to rise against most major currencies in 2010 according to a "smiling" model of the greenback’s performance at the beginning, middle and conclusion of major recessions in the United States.
The ‘Dollar Smile’ Hypothesis
Intuitively, one would suppose that the US Dollar should decline if the United States falls into a deep recession as the Federal Reserve cuts interest rates to stimulate economic growth, making the greenback unattractive relative to other currencies. However, a theory originally advanced by Stephen Jen, then an economist with Morgan Stanley, suggests something quite different. His logic goes as follows:
Phase 1: When the United States – the world’s largest economy and consumer market – falls into a deep recession, investors fearful that the downturn will spread globally sell off their holdings of risky assets (stocks, commodities) and move capital into the relative safety of cash and government bonds. The economic and geopolitical primacy of the United States along with the unmatched sophistication and liquidity its capital markets means that the cash and bonds of choice in this scenario are the Dollar and US Treasuries. This means that the greenback should rise if the US begins to experience a deep-enough recession to warrant fears of worldwide contagion.
Phase 2: As the pace of decline in economic activity invariably begins to slow, the markets become hopeful that the worst is over and capital begins to shift out of Dollar-denominated safe haven assets and back toward higher-risk and higher-return investments, sending US unit lower from its peak amid the crisis.
Phase 3: Finally, as economic recovery in the United States begins to gain momentum, investors start to speculate that the Federal Reserve will need to raise interest rates (which were surely lowered amid recession) to rein in building inflationary pressure, sending the US Dollar higher once again.
Broadly speaking, history seems to bear out Mr Jen’s hypothesis. As illustrated in the chart below, data going back to 1970 shows that the US Dollar Index (an average of the greenback’s value against six of its top counterparts) is higher when US Gross Domestic Product growth rates are either sharply above or below the average of other G7 nations; it is lower when the difference in growth rates declines, revealing a “convex” relationship or a “smile”:
Read more: DailyFX - Will Currency Markets Smile on the US Dollar?
The ‘Dollar Smile’ Hypothesis
Intuitively, one would suppose that the US Dollar should decline if the United States falls into a deep recession as the Federal Reserve cuts interest rates to stimulate economic growth, making the greenback unattractive relative to other currencies. However, a theory originally advanced by Stephen Jen, then an economist with Morgan Stanley, suggests something quite different. His logic goes as follows:
Phase 1: When the United States – the world’s largest economy and consumer market – falls into a deep recession, investors fearful that the downturn will spread globally sell off their holdings of risky assets (stocks, commodities) and move capital into the relative safety of cash and government bonds. The economic and geopolitical primacy of the United States along with the unmatched sophistication and liquidity its capital markets means that the cash and bonds of choice in this scenario are the Dollar and US Treasuries. This means that the greenback should rise if the US begins to experience a deep-enough recession to warrant fears of worldwide contagion.
Phase 2: As the pace of decline in economic activity invariably begins to slow, the markets become hopeful that the worst is over and capital begins to shift out of Dollar-denominated safe haven assets and back toward higher-risk and higher-return investments, sending US unit lower from its peak amid the crisis.
Phase 3: Finally, as economic recovery in the United States begins to gain momentum, investors start to speculate that the Federal Reserve will need to raise interest rates (which were surely lowered amid recession) to rein in building inflationary pressure, sending the US Dollar higher once again.
Broadly speaking, history seems to bear out Mr Jen’s hypothesis. As illustrated in the chart below, data going back to 1970 shows that the US Dollar Index (an average of the greenback’s value against six of its top counterparts) is higher when US Gross Domestic Product growth rates are either sharply above or below the average of other G7 nations; it is lower when the difference in growth rates declines, revealing a “convex” relationship or a “smile”:
Read more: DailyFX - Will Currency Markets Smile on the US Dollar?
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