The ‘Dollar Smile’ Tested by COVID-19

The theory of the “dollar smile” states that the dollar is strengthened when the American economy does well, but also when it doesn’t. Since the start of the pandemic, two of the three phases that are describes in the theory have happened. The third, the recovery, doesn’t seem to be in the cards.

The dollar tends to appreciate when the American economy does well, but also when it goes through difficult phases or the world economy suffers. This peculiarity is known as the “dollar smile.” This is explained by the currency’s international role in global commerce.

Why a smile? Because, according to the theory developed by former International Monetary Fund economist Stephen Jen, there are three distinct phases in the share price of the dollar, which take the form of a happy face. The far-left section corresponds to a strong dollar in a climate of general uncertainty. International investors look for safe assets, like U.S. Treasury bills, which they have to buy with dollars. This demand for dollars creates the rise.

The central part of the smile corresponds to a much lower value of the dollar, during periods of fragility in the American economy, which can result in low interest rates. The dollar, less lucrative, is less attractive. It may also be possible that the United States under-performs in comparison to the rest of the world.

Finally, the far-right section on the curve results from a situation in which the American economy goes through a recovery phase, which supplies a natural demand for the dollar and which can call for an increase in interest rates. The dollar becomes strong again.

Rush to the Dollar in March 2020

Did the theory withstand the COVID-19 pandemic? During the past year, the dollar experienced the first two phases of the smile. The period from the end of February to the start of March 2020, during the stock market crash caused by the pandemic, corresponded to the far-left section of the smile. “As the world’s major stock market indexes plunged into the red, there was a rush to the dollar as a safe haven,” according to the analysis of Thierry Larose, senior portfolio manager in the emerging markets bonds team at Vontobel Asset Management.

After having lost five cents against the euro between Feb. 22 and March 10, the dollar went from 0.87€ to 0.93€ in 10 days. A level that remained until mid-May and the start of a downward trend until the beginning of January 2021 — $1 was valued at 0.81 euros on Jan. 7, and has recovered moderately since then. The development was similar to that of the franc.

From mid-March 2020, massive interventions set by the authorities — central banks and governments in both the U.S. and Europe — have provided liquidity to calm the situation. The demand for dollars subsided.

Downward Trend

The result for the dollar: a downward tendency, also caused by a different phenomenon. “Stimulus packages will continue and the financial needs for U.S. dollars are such that the country cannot raise interest rates and the debt burden would become unsustainable,” explains Carl Vermassen, portfolio manager at Vontobel Asset Management. “The country has no choice but to let its currency slip away, as it has done on multiple occasions in the past.” This can be seen in the central part — the bottom — of the smile.

With the progress achieved in the fight against the pandemic and the restarting of the American economy, are we heading toward the far-right side of the smile, to a strong dollar? “Although upward phases cannot be ruled out, we think that it will remain stable or decline in the coming months,” Larose says. “It would be the result of opposing forces. On the one hand, the U.S. economy is recovering, resulting in increased pressure on the dollar. But on the other, the need for enormous financing, which requires a weak dollar.” The consensus in the markets is for a continued weakening of the U.S. dollar. The dollar smile is at risk of being asymmetric for a long time.

A Positive for Emerging Debt in Local Currency

The value of the dollar has a direct influence on assets considered as risky, the debt of emerging countries in their local currency, for example.

In general, the only thing that the emerging local debts have to fear is the dollar becoming strong for the wrong reasons (the bad side of the smile). The period of structural weakness of the dollar would be positive for this gigantic asset class, representing approximately $24.8 trillion.

In this very heterogeneous world, managers at Vontobel would rather invest in the winners of the pandemic, that is to say China and Asia in general (like South Korea, Singapore or Indonesia), even if their currencies aren’t cheap. Brazil and Mexico are also thought of positively compared to Central European countries, which need the weakest possible currencies to remain competitive with Western Europe.