- Introduction
This was the time when the U.S. dollar witnessed a significant boost amidst the global recession. Many times, looking at the market conditions, people would think the U.S. dollar would fall, but surprisingly it continues to grow.
Why does that happen?
The Dollar Smile Theory answers this question.
Following are the three scenarios that Morgan Stanley put forward to explain the positive growth of the U.S. Dollar.
The Strength Due To Risk Aversion
The first reason that the U.S. dollar rise is due to risk aversion. This is a situation where investors rely more on safe-haven currencies such as the dollar, yen, etc. During this period, investors consider the global economy in an unstable position. Hence, they are less likely to invest in the risky asset; instead, they put their cash on U.S. dollars.
The Dollar Weakens to New Low – Economic Recession and Slowdown
Under this scenario, the US dollar falls to a new low. The bottom of the smile indicates the dull performance of the currency as the economy struggles with weak fundamentals. Additionally, the possibility of falling interest rates also impacts the position of the U.S. Dollar. This results in the market participants steering clear from the dollar.
Subsequently, the primary motto of the U.S. Dollar becomes to Sell. Investors move from buying the currency to selling it and moving towards currencies that are providing higher yields.
The Strength Of The U.S. Economy Helps
The U.S. dollar continues to grow because of the strong economy of the country. After the low, a new smile emerges as the economy sees its light at the end of the tunnel. With the signs of the recovery of the economy, a sense of optimism spreads through the market.
This increases the sentiments towards the dollar again. With the US economy enjoying higher GDP growth, the greenback continues to appreciate. This increases the interest rate in the international market.
Let’s take a look at the Dollar Smile Theory in reality…
As you can see, due to the global pandemic which has caused a lot of economies all over the world to suffer, the U.S. dollar is acting as a safe haven currency. All countries, including the U.S., aren’t doing so great.
The key is relative economic growth. If growth from other countries is growing, but the U.S. economy is growing even faster, then the U.S. dollar will swing upward to the right side.
So will the Dollar Smile Theory hold true? Only time will tell!
Though the theory is quite relevant and backed by some logic, the economy is extremely volatile. So only time will tell how definite the Dollar Smile theory is in the future.
In any case, this is an important theory to keep in mind. Remember, all economies are cyclical. They strengthen, then they weaken, they strengthen, then they weaken, and repeat.
The key part is determining which part of the cycle the U.S. economy and then compare how it’s doing against the rest of the world .
sources:forex.academy .babypips.com
this article is For information purposes only!
