Fundamentals are still smiling at the dollar

There is a simple framework we can use to help evaluate the likely intermediate-term trend of the US dollar, measured in months and quarters. It is referred to as the dollar smile. I first saw this concept in a research note written by Stephen Jen, when he was with Morgan Stanley many years ago. I do my best to keep it in mind as I trade Mr. Greenback, as at times it helps keep me out of the weeds. At the moment the dollar smile is indeed happy with the buck.

 Three scenarios gleaned from the dollar smile:

 1)        Left side of the smile reflects an appreciating dollar as global risk comes back into the financial system. From our current perspective, we are thinking about a major “risk off” safe haven bid into the dollar resulting from a big drop in the stock market. Though such a risk bid can be short-lived, it can be a powerful initial driver sustained by relative fundamental factors over the intermediate term.

2)         The middle of the smile reflects dollar depreciation against the major currencies as the US economy decelerates or muddles through soft spots, while relative economic growth and yield (central bank policy catchup) begin to improve among in both the developed and developing world economies; i.e. some global inflation.    

3)         The right side of the smile reflects an appreciation in the dollar on the back of strong US growth and rising yield differentials. This backdrop pulls in hot money and a greater share of foreign direct investments as the US economy grows faster than key country competitors and the Fed is expected to hike rates faster than other major central banks (CBs). This process naturally tends to be self-reinforcing. 

Below is a chart showing the path of 2-year relative yield spread favoring the US dollar compared to the euro, pound, Australian dollar, and Canadian dollar. Yield spread keeps grinding in favor of the dollar.