FX 101: USD Smile and portfolio impacts from King Dollar FX 101: USD Smile and portfolio impacts from King Dollar FX 101: USD Smile and portfolio impacts from King Dollar

FX 101: USD Smile and portfolio impacts from King Dollar

Forex 4 minutes to read
Charu Chanana

Head of FX Strategy

Summary:  The FX 101 series is aimed at explaining key concepts in the FX markets. This article delves into the USD smile theory and why the dollar is king. We discuss the reasons behind its safe haven status and why it is used for hedging. But a strong dollar can hurt portfolios, so we also delve into some strategies that can be considered to rebalance portfolios in a strong dollar environment.

The ‘USD Smile’ Theory

The Dollar Smile Theory is a concept that suggests the value of the US dollar tends to strengthen during periods of economic prosperity and periods of economic uncertainty, while weakening during periods of moderate economic growth.

Source: Saxo

The "smile" in the theory refers to the shape of the curve when plotting the strength of the dollar against different economic conditions.

  • During times of economic expansion and strong growth, investors seek out the USD for its high yield and attractive returns on investments.
  • On the other hand, during times of economic downturns and uncertainty, or risk-off, investors also flock to the US dollar as a safe haven asset, seeking stability and a refuge from market volatility and geopolitical risks.
  • However, the USD does poorly when the US economy is muddling through. It is important to note here that ex-US growth has to be on a stronger footing to drive flows out of the dollar-denominated assets and into riskier but better-performing assets.

Dollar has a Carry Advantage

A conventional carry trade strategy (systematically selling low-yield currencies against high-yield currencies) is probably the most widely known strategy in the currency market. With a rapid pace of tightening from the Fed over the last two years, the dollar has started to look like the best bet for carry traders. US interest rates are high compared not just to the extremely low (or negative) rates in countries like Japan or Switzerland, but also higher than that in Australia, Eurozone and Canada.

US interest rates are higher than its global peers. Source: Saxo, Bloomberg

Dollar as a Safe Haven

The US dollar is often considered a haven currency due to several factors:

  • Liquidity: USD is the most widely traded currency in the world, providing high liquidity and easy access for investors during times of market stress.
  • Global reserve currency: USD serves as the primary global reserve currency, held by central banks and institutions worldwide, which enhances its status as a safe haven asset.
  • Stability and confidence: Despite fluctuations, USD is perceived as a stable currency backed by the economic strength of the United States and the credibility of its monetary policy.
  • Flight to safety: During periods of uncertainty, investors often seek safety in US assets, including Treasury bonds and the US dollar, driving up its value relative to other currencies.

Dollar is also a Hedge

The US dollar tends to have low or negative correlation with other asset classes such as stocks, bonds, and commodities, making it an effective diversification tool to hedge against specific risks associated with those assets. This, along with its other characteristics of USD being a safe-haven asset with high liquidity and a reserve currency, makes it an effective hedge in portfolios.

The US dollar is the world’s dominant vehicle currency. It was on one side of 88% of all trades in April 2022, according to BIS survey. It is extensively used in international trade and finance, making it indispensable for conducting business transactions, settling trade accounts, and pricing commodities. This widespread use and acceptance provide investors with confidence in its value, making it a preferred hedge against currency risks in global markets.

Since June 2022, every month that dollar has closed higher, all other asset classes have closed lower.

Demand-Supply Dynamics

The demand of US dollar is determined by the amount of demand for US exports, or by the demand of the USD and USD-denominated financial assets such as stocks or Treasury bonds. The Federal Reserve plays a key role in managing the supply of US dollar through its monetary policy tools, which include open market operations, reserve requirements, discount rate setting, interest rate policy and quantitative easing/tightening (QE/QT).

During the pandemic, the Federal Reserve adopted QE as it bought assets like government bonds to inject money into the financial system. It is now doing QT, i.e. reducing its balance sheet by approximately $100 billion per month. As QT pulls money out of the economy, USD supply is curbed and this increases the value of the dollar.

Strong Dollar can Hurt Portfolios

Given its widespread uses, the USD strength has implications for all market participants. There are various ways in which USD can impact your portfolio:

  • Impact on US exporters: Companies that rely heavily on exports may face challenges when the dollar strengthens, as their products become more expensive for foreign buyers. This can potentially lead to lower sales and profitability for exporters, and a risk of earnings disappointment which can lead the stock lower. Sectors like technology and auto have high exposure to non-US revenues, while those like homebuilding or utilities are least exposed.
  • Impact on US trade balance: Given the widespread use of the dollar for trade invoicing and financing, appreciation of the dollar can weaken global trade. When the dollar appreciates, export prices, which are sticky in the short term, do not change much, while import prices in local currency increase, depressing import demand. Higher import prices also lead to inflation scare for importing nations.
  • Risk sentiment impact: As USD is the main funding currency in global capital markets, a stronger dollar is generally associated with tighter global dollar funding conditions, tighter balance sheet constraints for borrowers with dollar debt and diminished appetite for risk-taking more broadly.
  • Impact on emerging markets: Some emerging markets could be destabilised due to the increased burden of their USD-denominated debt with the rise in USD. This raises the risk of a default for the more vulnerable frontier economies.

Mitigating Risks or Rebalancing Portfolios in a Strong Dollar Environment

While hedging FX risks in a portfolio may be one of the ways for market participants to reduce the volatility of their equity investment. But currency hedging requires active monitoring and regular adjustment in portfolios. Wide interest-rate differentials between the dollar and other currencies could make hedging costly, particularly for long term investors as returns of hedged vs. unhedged portfolios tend to be similar over a long-term horizon. Diversification is probably a better tool to reduce volatility than FX hedging.

However, there can be other ways to benefit from a strong dollar trend for market participants, and these should be carefully considered. For instance,

  • Market participants with a high exposure to USD-denominated assets, but cautious of event risks, could hedge their portfolios by being long US dollar.
  • If you have a large exposure to US tech stocks or other sectors that depend heavily on non-US revenues, then you could consider portfolio rebalancing and adding an exposure to sectors which have less dependence on non-US revenues such as utilities.
  • A strong dollar can put downward pressure on commodity prices, as commodities are typically priced in dollars. It may be worth looking at your exposures and adjusting your portfolio in-line with your goals taking the dollar strength into account.
  • A strong US dollar could make foreign assets cheap for a US-based investor. This can be useful for investors waiting to add ex-US or EM exposure to their long-term portfolios. However, caution is needed as a strong US dollar also increases the debt burden for EMs and could limit their ability to expand fiscal spending and support demand/growth.
  • A strong dollar can attract capital flows into US assets, including stocks, bonds, and real estate, as investors seek higher returns and safety. This can impact asset prices and valuations across different markets and asset classes.

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