Stephen Jen, a former economist at the International Monetary Fund and Morgan Stanley, came up with a theory that explains how the USD behaves in different circumstances and called it “The Dollar Smile Theory”.
The dollar smile theory states that the USD tends to strengthen both when the US economy outperforms its peers but also when the US economy is extremely weak (like recession or extreme risk off sentiment) or when there’s a global growth slowdown.
There's a saying "when the US sneezes the world catches a cold". The US economy is the biggest in the world and US financial markets are the most stable and liquid ones. Therefore, it shouldn't surprise that when the US gets in trouble, the whole world is affected.
New traders had the privilege of seeing this theory work in real time during the past 2 years. In 2020 with all the massive stimulus enacted by governments and central banks, the global economy rebounded quite strongly from the shortest recession in history and the USD depreciated as positive risk sentiment and prospects of global growth ahead resulted in risk assets being bought heavily while the safe assets got sold.
In 2021 global growth started to slow down amid rampant inflation, Chinese housing market issues and waves of new variants. The USD gained for almost the entire year as risk off sentiment prevailed and inflation, much above the Fed's target, made the market expect a tighter monetary policy and even a faster than expected one.
This article was written by Giuseppe Dellamotta.
