Is the US dollar smile starting to fade amid economic headwinds?

Higher interest rates, tighter credit conditions and a steadily depleting stock of household savings all add to the case for a US recession and potentially a period of weak global growth
So shouldn’t this mean an appreciation in the US dollar? It depends.

Kerry Craig

Published: 9:00pm, 14 Apr 2023

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Read enough about currencies and you’ll come across the term “dollar smile”. When times are good and risk sentiment is high, the US dollar usually does well, as investors flock to the growth potential of US assets. Alternatively, when times are bad and investors are cautious, they seek out high-quality safe havens like US Treasuries, creating upward pressure on the US dollar.

These are the two corners of the US dollar smile. When the outlook is mediocre, investors usually seek out investment opportunities outside the United States, and the greenback depreciates.

Since its most recent peak last September, the US dollar has fallen by 10 per cent as the economic outlook has been increasingly shifting towards a recession, a case that is stronger in the US today than it was a few months ago.

Higher interest rates, tighter credit conditions and a steadily depleting stock of household savings all add to the case for a US recession and potentially a period of weak global growth. So shouldn’t this mean an appreciation in the US dollar?

As with all good answers, it starts with “it depends”; in this case, on the time frame. While currencies can be exceptionally noisy and move quickly on any given day, week or month, the US dollar tends to move in longer cycles of alternating strength and weakness.

From the mid-1990s until the early 2000s, the US dollar climbed steadily, then entered a period of prolonged depreciation for the best part of 10 years, before starting the current climb again in 2012.

There are reasons to believe that the most recent decline may be the start of a longer downward cycle in the US dollar story. The elevated price of the US dollar stands in contrast to the fundamentals of the US economy and the shorter-term impacts of growth and interest rate differentials between the US and the rest of the world.

In the near term, that direction of the currency is likely to be determined by the difference in the expected growth in the US versus the rest of the world and the difference in the level of interest rates.

Money flows to where it can earn the highest return. Typically, countries with higher interest rates see their currency appreciate. The aggressive hiking led by the US Federal Reserve was one reason the US dollar gained through most of 2022.

However, with the Fed nearing the end of its hiking cycle as inflation falls, while other central banks – such as the European Central Bank – continue to raise rates or, like the Bank of Japan, normalise monetary policy from an ultra-loose stance, then the flow of money will move away from the US and its currency.

A better economic outlook outside the US would create downward pressure on the US dollar if investors increasingly look for investment opportunities outside the United States and the elongated period of American exceptionalism is challenged. The US equity market has returned 12.6 per cent on an annualised basis in the 10 years to 2022, compared to 7.6 per cent for European equities and 5.1 per cent for Asia ex-Japan.

However, China’s reopening has further to go, lifting expectations for regional growth. Meanwhile, the energy crisis continues to fade as a headwind to European growth. This raises the potential for a change in global equity market leadership.

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The US dollar looks expensive. Even with the 10 per cent fall since September, the currency is still 40 per cent higher than its low in 2011. This is at odds with the variables that are often used to define a currencies long-term “fair value”, such as the size of a country’s trade deficit or fiscal position, both of which are weak in the US’ case.

The difficulty in deciphering which way currencies may go comes from the large number of variables that can influence their performance, most notably sentiment. While the elements outlined above construe the case for a longer depreciation in the US dollar, a swift change in market sentiment can swamp these factors, and the strength of the flight to safety is a powerful force.

The consensus view of a mild recession in the US, and a rate cycle that is very near the top, play well into dollar depreciation. However, should aftershocks of the mini banking crisis be more severe or the another inflation shock present itself, the flight to safety may again turn the dollar frown upside down.

Kerry Craig is a global market strategist at JP Morgan Asset Management