The Dollar’s ‘Smile’ and Its Implications on Currency Markets
The Dollar’s Predicament
Only a return of more aggressive Fed easing speculation or a switch out of relatively expensive U.S. stocks seems likely to wipe the dollar’s smile off its face.
The Dollar Smile Model
Currency markets still appear to be in thrall to the so-called “dollar smile” – the model that posits two extreme scenarios which both tend to boost the dollar.
The Dollar’s Behavior
The theory is essentially this: the dollar rises in good times (relatively strong U.S. growth, “risk-on” markets and high asset returns) and in bad (times of global risk aversion that draw domestic capital home to cash and overseas money to the safety of U.S. Treasuries), but sags in between.
Current Underpinnings
Right now, the dollar is being underpinned to varying degrees by both sides of that smile: market turmoil in China, recession in Japan and Britain, and geopolitical tensions around the globe on one; a stubborn Federal Reserve that is in no rush to ease policy ahead of other central banks, and a booming tech-led Wall Street on the other.
Market Sentiment
Long-forecast dollar declines seem exaggerated and short positioning increasingly under water. What’s more, currency markets are quite relaxed about it – as the dollar climbed to a three-month high against a basket of major rivals this week, implied volatility across major currencies has slid to a two-year low.
Factors Affecting Dollar’s Movement
So far this year, Wall Street is up, Treasury yields are holding firm, and the dollar is proving hard to unseat. Two factors could push the dollar higher still in the near term – investor positioning and rate differentials.
Market Speculation
While many of the big investment banks, such as JP Morgan, HSBC and Deutsche Bank, are recommending their clients buy dollars over other currencies, the speculative trading community has yet to fully get on board.
Global Rate Expectations
That’s a bold call when relative U.S. and euro zone rate expectations are shifting further in the dollar’s favor – rates markets are now pricing in around 120 basis points of policy easing from the European Central Bank this year and 100 basis points from the Fed.
Impact of U.S. Rates and Yields
The dollar has appeared more sensitive to U.S. rates and yields recently than equities, tending to rise and fall with bond yields irrespective of the corresponding moves in stocks.
Forecasts and Predictions
Deutsche Bank’s Alan Ruskin reckons the dollar’s sensitivity to the Fed’s first move is such that if the U.S. central bank doesn’t cut rates in May, the euro will fall towards $1.05. His counterparts at JP Morgan agree, and even float the possibility that the euro tests 1-to-1 parity with the dollar in the coming months if the euro zone’s economic downturn deepens.
Assessment of the Dollar’s Future
“The 2024 Fed rate cuts will come amid the most synchronized global easing cycle in recent history, leaving U.S. yield spreads elevated. The Fed’s dovish pivot by itself is thus not enough to be bearish (on the dollar),” they wrote on Tuesday.
By Jamie McGeever; Editing by Paul Simao
