Have you ever wondered why the dollar strengthens during the economic downturn and prosperity? Well, others have similar questions. In fact, a smart brother who worked for Morgan Stanley proposed a theory to explain this phenomenon.
Ren Yongli, a former currency strategy analyst and economist, proposed a theory and named it “Dollar Smile Theory.” His theory portrays three scenarios that guide dollar behavior.
Scenario 1: The dollar appreciates due to risk aversion. The first part of the smile shows that the dollar benefits from risk aversion. Risk aversion allows investors to escape to “safe refuge” currencies such as the US dollar and Japanese yen. As investors believe that the global economic situation is unstable, they are hesitant to continue to pursue risky assets, increase their willingness to buy lower-risk US dollars, and ignore the state of the US economy at all.
Scenario 2: The US dollar drops to a new low. The bottom of the smiley face reflects the bleak performance of the US dollar, which is due to the weakening of the fundamentals of the US economy. The possibility of cutting interest rates will also depreciate the US dollar. This caused the market to start circumventing the dollar. Regarding the US dollar, their motto becomes “Sell! Sell! Sell!”
Scenario 3: The US dollar appreciates due to economic growth. In the end, the smile showed, because the US economy finally saw the light of hope. Optimism is on the rise, signals of economic upturn are appearing, and investor confidence in the dollar is heating up. In other words, as the US economy enjoys a strong GDP growth rate and the expected increase in interest rate hikes, the dollar begins to appreciate.
When the financial crisis appeared in 2007, this theory seemed to have begun to work. Remember when the global recession peaked, the dollar strengthened significantly? This is the first stage.
When the market finally bottomed out in March 2009, all of a sudden, investors began to switch to high-yield currencies, which earned the dollar the honor of being the “worst performing currency” in 2009.
So the dollar smile theory holds?
Time will prove everything.
In any case, this is a theory to keep in mind. Remember, the economy is cyclical.
The key is to find the position of the economy in the cycle.