QUANTIFYING THE US DOLLAR SMILE THEORY – SPECIAL REPORT:

• The US Dollar has a unique reserve currency role in foreign exchange markets
• This means USD tends to rise when the local economy greatly grows and falls
• You will get to learn about the Dollar Smile Theory, backed by economic data

A “floating” currency – or one that is influenced by the natural forces of the market - tends to have a positive relationship with its economy. In other words, if growth is expected to outperform and bolster inflation, causing the central bank to raise interest rates, that tends to boost the currency and vice versa. There are always exceptions, however, such as the US Dollar.

Have you ever heard of the “Dollar Smile Theory”? This is a concept that helps explain why the US Dollar tends to rise when the economy is not only strongly outperforming, but also when it is experiencing trouble, such as a recession. Everything in between these two extremes is where the currency often finds itself under pressure.

To understand why this relationship exists, you need to have a basic understanding of the US Dollar’s unique role in global financial markets. It is the global reserve currency. According to the Bank for International Settlements, in 2019 the USD was used in about 90% of global FX transactions. This means it is the world’s most liquid trading instrument.

The saying goes when the US sneezes, the world catches a cold. During times of economic stress, flight to safety means traders often need to liquidate market positions. Their go-to choice is often US Dollars, making it a haven-linked trading instrument. This influx of demand helps explain why the currency tends to rise during recessionary periods. Compared to a handful of assets, the US Dollar tends to do the best during the onset of recessions in the United States.

The chart below visualizes the “Dollar Smile Theory”. But, how can you use this information to your advantage? Well, the purpose of this article is to quantify the concept and show you how this relationship works in the real world. I will be looking at the dollar’s interaction with the following economic data: gross domestic product (GDP), the unemployment rate, ISM manufacturing PMI, and vehicle sales. By the end of the article, hopefully, you can walk away with a better understanding of USD.

US Dollar Smile Theory

Setting Some Ground Rules

Before diving into economic data, let us set some ground rules. The first is that all the data is quarterly since 1976 expressed in year-over-year terms. The second is that for each economic indicator, I have removed extreme outliers (beyond +- 3 standard deviations from the average). What is left behind is underlying data matching an underlying US Dollar.

This helps increase the statistical significance and reduce variability. Also, for the most part, each economic indicator will have outliers removed from different quarters. Finally, I will be using the Bloomberg Correlation-Weighted US Dollar Index (BCWI). This is because I want to capture the general movement in the currency as opposed to a given exchange rate.

Testing Gross Domestic Product (GDP)

Can you spot the “U-shaped” relationship between GDP (or economic growth) and the US Dollar below? That is the smile theory put into action with real economic data. The curve can be broken down into two green zones on the left and right (where USD is expected to be positive for given values of GDP), and a red zone (where the currency is anticipated to weaken). Somewhere between 1.5% – 4.0% GDP (Y/Y) is the “damage” zone for USD, or when the currency is seen falling compared to a year ago. Values of growth outside of this range show USD rising on average.

It should be noted that there is a plethora of factors that can impact how the USD performs in a quarter compared to a year ago. That is why sometimes you will see the dollar doing well around the “red zone” of GDP and poorly in the “green zone”. The purpose of this study is to focus on just the economic indicator alone, highlighting a non-linear relationship with the US Dollar.

Testing the Unemployment Rate

What about the unemployment rate? Like GDP, there is also a “U-shape” relationship with the US Dollar. The tricky thing here is that you need to think about unemployment in reverse terms compared to GDP. When the unemployment rate is rising, that is not good for an economy and vice versa.

In this data, it seems the “danger” zone for the US Dollar is when the unemployment rate is seen performing somewhere between -5% and +25% (Y/Y). When this economic indicator clocks in outside of this range, the US Dollar has historically tended to rise against its major counterparts.

Unemployment Rate YoY Quarterly Since 1976 (Outliers Removed)

Testing ISM Manufacturing PMI

Now let us look at ISM Manufacturing PMI to gauge the impact of activity in the industrial sector on the currency. Here too you can find a “U-shaped” relationship. It seems that the “danger” zone for the US Dollar is when this indicator performs -5% to +30% (Y/Y). Outcomes outside of this range seem to open the door for the US Dollar to outperform.

ISM Manufacturing PMI YoY Quarterly Since 1976 (Outliers Removed)

Testing Vehicle Sales

Finally, I will wrap this up with the total number of new vehicle sales, expressed in year-over-year terms. Just like GDP, the unemployment rate and ISM manufacturing PMI, you can also see a “U-shaped” relationship with the US Dollar. The “danger” zone for the currency seems to occur when vehicle sales report between -7.5% and +7.5%. Meanwhile, the US Dollar on average tends to appreciate when outcomes are outside of this zone.

Vehicle Sales YoY Quarterly Since 1976 (Outliers Removed)

Conclusion

With that in mind, hopefully, you have a better idea of what the US Dollar Smile Theory is and how it works in real life. The key takeaway is that the currency tends to appreciate handsomely when economic data greatly outperforms and significantly underperforms, such as during recessions. Somewhere in-between these extreme outcomes are where the currency tends to weaken, and I tried to quantify that for you. If you have enjoyed this special report, feel free to follow me on Twitter for ongoing updates!

https://www.dailyfx.com/news/us-dollar-smile-theory-how-does-economic-resilience-or-recession-drive-usd-20230417.html