The dollar tends to appreciate when the US economy is doing well, but also when it is going through difficult times or the world economy is suffering. This feature is known as the “dollar smile”. It is explained by the international role of this currency used in world trade.
Why a smile? Because, according to this theory formulated by a former economist of the IMF, Stephen Jen, there are three parts in the curve of the dollar, which displays the shape of a happy boil. The upper left corner of the smile is a strong dollar amid general uncertainty. International investors look for safe assets, like US Treasuries, which they should buy in dollars. This demand for the greenback is causing it to rise.
The middle part of the smile is a lower value of the US dollar, during times of weakness in the US economy, which can result in low interest rates. The dollar, less profitable, is less attractive. The United States may also be underperforming the rest of the world.
Finally, the upper right corner of the curve stems from a situation in which the US economy is experiencing a recovery phase, which is fueling natural demand for the greenback and may require a rise in interest rates. The dollar is strong again.
Rush to the dollar in March 2020
Has the theory stood up to the Covid-19 pandemic? During the past year, the greenback has experienced the first two phases of the smile. The period from late February to early March 2020, during the stock market crash caused by the covid pandemic, corresponded to the upper left corner of the smile. “While the world’s major stock market indices were sinking into the red, we saw a rush towards the dollar as a safe haven,” analyzes Thierry Larose, portfolio manager specializing in emerging markets at Vontobel Asset Management.
After losing 5 cents against the euro between February 22 and March 10, the dollar fell from 0.87 to 0.93 euros in ten days. A level maintained until mid-May and the beginning of a downward movement until early January 2021 – 1 dollar was worth 0.81 euro on January 7, it has recovered modestly since. The evolution was similar compared to the franc.
From mid-March 2020, the massive and determined interventions of the authorities – central banks and governments, in the United States and in Europe – have provided enough liquidity to restore calm. The demand for dollars has subsided.
Consequence for the dollar: a downward trend, also fueled by another phenomenon. “The stimulus programs will continue and the financing needs in United States dollars are such that the country cannot raise its interest rates, the debt load would become unbearable, specifies Carl Vermassen, portfolio manager at Vontobel Asset Management. The country has no choice but to let its currency slip away, as has been done several times in the past. ” We would then be in the central – and low – part of the smile.
With the progress made in the fight against the pandemic and the restarting of the US economy, are we heading towards the upper right corner of the smile, which corresponds to a strong dollar? “Even if phases of increase are not excluded, we believe that it will remain stable or decline over the next few months, continues Thierry Larose. It would be the result of opposing forces. On the one hand, the US economy is picking up, which translates into upward pressure on the dollar. But on the other, the titanic financing needs, which require having a weak dollar ”. The market consensus is for continued weakening of the US dollar. The dollar’s smile is likely to be asymmetrical for a long time.
Positive for emerging debt in local currency
The value of the dollar has a direct influence on assets considered to be risky, the debt of emerging countries in local currency in particular.
Generally speaking, the only thing EM debt in local currency fears is that the dollar is strong for the wrong reasons (on the wrong side of the smile). The period of structural weakness of the dollar would therefore be positive for this gigantic asset class representing around 24.8 trillion dollars.
In this very heterogeneous universe, the managers of Vontobel invest more in the winners of the pandemic, that is to say China and Asia in general (including Korea, Singapore or Indonesia), even if their currencies are not particularly cheap. Brazil and Mexico are also judged positively, unlike the countries of Central Europe, which need the weakest possible currencies to remain competitive against Western Europe. S. R.