The Dollar Smile Puts Investors in a Happy Place

By John Banks

As a general rule, the U.S. dollar is strong under two conditions. If the dollar is strong, either the economic outlook is exceptional for the United States alone, or the outlook is bad — possibly crisis-level bad — for the rest of the world (and potentially for the United States, too).

These conditional extremes — where the dollar is strong either in times of notable U.S. strength or notable global distress — create a phenomenon known as “the dollar smile.”

  • On one side of the smile, the dollar is strong when investment capital is flowing heavily into the United States.
  • On the other side of the smile, the dollar is strong when capital is fleeing risk assets and heading into safe havens like U.S. treasury bonds.
  • In the middle of the smile — when the global economy is humming along — the value of the dollar generally declines. (This is what creates the lower portion of the smile.)

Why does the dollar generally behave like this?

In part because the U.S. dollar, as the world’s reserve currency, is the most important currency in the world. Global commodities are generally priced in dollars, and a majority of global trade transactions involve dollars (even when the U.S. is not involved).  

As the issuer of that all-important world reserve currency, the United States in some ways behaves like the banker in a game of Monopoly, or a financier helping the rest of the world make transactions. It is the implicit job of the world’s banker and financier to make sure plenty of currency and dollar-based credit is available for international transactions to take place.

And so, in normal times, America makes plenty of U.S. dollars available for the world to use in its transactions, and U.S. consumers further send large quantities of dollars into the world via the buying of imports. Meanwhile, various countries around the world do a lot of business in dollars, and then park their extra dollar assets in U.S. Treasuries. 

This activity, along with routine financial transactions that provide dollar-based credit for global trade, tend to weaken the dollar overall. All of these dollars going out, and circulating around, tend to increase the available supply of dollars, which causes the value of the dollar to fall on average.

Again, under normal conditions, this weakness is a feature of the system, not a bug. It lets the U.S. dollar perform like a lubricant that greases the wheels of world trade. If some other currency were the world reserve currency, it would behave in a similar way.

If the U.S. economy is exceptionally strong compared to the rest of the world, however, the dollar will tend to be strong, too — thus creating the left side of the smile — as international capital flows into, rather than out of, the United States.

The U.S. dollar was extremely strong in the latter half of the 1990s, for example, as first Asia and then Russia experienced financial crises while investors piled into a strong U.S. stock market.

The dollar was also tremendously strong in the early 1980s, as the U.S. emerged from recession and a new bull market developed, until an international agreement was struck in 1985 (the Plaza Accord) to push the value of the dollar lower.

When the dollar is weakening and drifting lower — the normal state of affairs at the bottom of the smile — the result is a kind of easy-money finance regime for emerging markets and commodity exporters.

As a rule, a weakening dollar means rising commodity prices, which in turn means larger profits for emerging-market economies and commodity exporters (and also for U.S. exporters and farmers).

The prospect of commodity-based profits then causes more investment capital to flow toward emerging markets and commodity producers. As this capital flows out of the United States, and into the rest of the world, it causes the dollar to weaken further in a virtuous cycle.

Ever since the Pfizer, Moderna, and AstraZeneca vaccines were announced, we have witnessed the dollar smile effect on steroids.

Prior to the vaccine announcements in November, the 2021 global economic outlook was still in doubt. But after the effectiveness of all three vaccines was confirmed, the prospect of a robust, vaccine-powered global recovery seemed assured.

That prospect, in turn, allowed capital to rush back into emerging-market assets and to further bid up commodity prices, causing the U.S. dollar to decline even faster as investor currency went out into the world (with dollars being sold to buy local stocks or bonds in various countries).

The speed at which the dollar has declined in recent days was a function of the whiplash created by the suddenness of the bullish vaccine shift. Immediately and out of the blue, in the space of a week or two, a trio of vaccine game changers meant the 2021 recovery outlook was suddenly better than investors could have hoped.

We should note that the dark side of the dollar smile — when the U.S. dollar spikes higher in a time of distress or outright crisis — is exactly what we saw in March 2020, when the full weight of the pandemic caused a market crash.

As risk assets sold off dramatically in March, and leveraged investors faced margin calls with wave after wave of forced selling, a flood of capital rushed for the safety of U.S. Treasury bonds, thus pushing up the price of the U.S. dollar (as U.S. Treasuries are denominated in dollars, which means buying treasuries is the same as buying dollars).

A crucial question at this moment is how long the U.S. dollar can continue to maintain its current downtrend — or to put it another way, how long the dollar can stay at the bottom of the smile. 

This matters because, as long as the dollar keeps weakening and drifting lower — or alternatively flatlining without rising much — commodity prices can keep on pushing higher, with emerging market assets looking increasingly attractive, too.

Some contrarians point to data that shows dollar index futures are at historically oversold levels, which increases the odds of a snapback rally.

If the trading community is extremely short the U.S. dollar — meaning they are betting in historic size on the dollar’s continued decline — that increases the odds the dollar could rally sharply at some point.

And yet, from another point of view, it is possible that dollar-bearish forex traders are like the sparrow on the hippo’s back compared to the larger forces at work.

The hippo in this metaphor — meaning the entity that matters far more than the sparrow — would be the world’s central banks and large investment institutions, who are still collectively sitting on a mountain of dollar-denominated assets.

If central banks are steadily selling off a portion of their dollar-denominated assets (like U.S. Treasuries) and reinvesting that capital in emerging-market equities or bonds, or commodity assets, or some other investment locale other than the United States, that steady selling pressure could create downward trend movement in the U.S. dollar that lasts for years.

Imagine, say, that the world’s central banks and institutions have 60% of their capital in U.S. dollar assets, and then decide to cut that overweighed portfolio amount back to 40%. A 40% weighting would still be a very significant dollar exposure weighting, just not as significant as before.

And yet, the divestment involved in the world collectively dropping its U.S. dollar holdings from 60% to 40% (just to give a plausible example) would amount to trillions upon trillions’ worth of dollar selling, spread out over a multi-year time period.

And why might that kind of divestment start happening now?

Because the prospect of a vaccine-powered recovery has put the dollar smile in a happy place for investors — with respect to emerging-market assets and commodities, that is — as 2021 rebound prospects look bullish for the world.

When it is all added together, we are looking at a potential virtuous cycle of dollar weakness.

In this cycle, an ongoing decline in the dollar helps emerging-market assets and energy and commodity prices rise, which in turn causes central banks and institutions the world over to sell more dollar assets in order to invest in commodity producers and emerging-market bonds — and their divestment then causes the dollar to fall even more.

If the dollar smile stays weak for a long while in this manner, investors will keep smiling, too.