With the Fed hiking cycle now almost complete, everyone in the FX market is trying to figure out when the Fed will switch to an easing bias and how the dollar will react. The widely-used "dollar smile" framework has been the go-to for understanding the dollar's response to a dovish turn but is it correct?
In a report from Deutsche Bank today, a simpler framework is proposed, focusing on front-end rates and 'bad news' to explain the dollar smile. The key finding is that US rates tend to bounce back faster from negative shocks than global rates, which contributes to dollar outperformance on negative shots. Rate spreads play a significant role in explaining the phenomenon, even though other risk-off channels also have an impact.
"In the last forty years, dovish Fed repricings on the back of very bad news-geopolitical stress, financial turbulence, sovereign debt or currency crises, or trade wars-have typically been exceeded by repricings in the rest of the world," Deutsche Bank writes.
Interestingly, the type of bad news behind repricings doesn't significantly affect the outcome. The immediate trading implication is that as long as the front-end rate spread between the US and Europe converges, EUR/USD and GBP/USD may continue to strengthen, even if global risk sentiment turns sour. The crucial factor will be whether the ECB and BOE can maintain their course in response to inflation once the Fed pivots to an easing bias.
Interestingly, the man who coined the 'dollar smile' framework -- Stephen Jen -- is also out with a report today arguing that the US dollar is losing ground as the global reverse currency.
"The USD is losing its market share as a reserve currency at a much faster rate than is commonly believed. After steady declines in its global market share for the past two decades, in 2022 the dollar lost market share at a pace 10 times as rapidly. Analysts have failed to detect this big change because they calculate the nominal value of the world’s central banks’ dollar holdings without considering the changes in the price of the dollar. Adjusting for these price changes, the dollar, we calculate, has lost some 11 percent of its market share since 2016 and double that amount since 2008."
The decline in the USD's reserve currency status has been particularly significant since the start of the war in Ukraine, prompting concerns among large reserve-holding countries. However, Jen writes that overcoming the strong network effects that support the dollar's international currency status is difficult. The dollar's eventual decline as an international currency depends on the stability and growth of financial markets outside the US compared to those within the US and although trends are heading in that direction, the dollar's demise is not an imminent risk.
