US Dollar Prospects for Traders in 2010

02/04/2010 12:01 am EST

Focus: FOREX

The US dollar is likely to rise against most major currencies in 2010 according to a "smiling" model of the greenback’s performance at the beginning, middle, and conclusion of major recessions in the United States.

The “Dollar Smile” Hypothesis

Intuitively, one would suppose that the US dollar should decline if the United States falls into a deep recession as the Federal Reserve cuts interest rates to stimulate economic growth, making the greenback unattractive relative to other currencies. However, a theory originally advanced by Stephen Jen, then an economist with Morgan Stanley, suggests something quite different. His logic goes as follows:

Phase 1: When the United States—the world’s largest economy and consumer market—falls into a deep recession, investors fearful that the downturn will spread globally sell off their holdings of risky assets (stocks, commodities) and move capital into the relative safety of cash and government bonds. The economic and geopolitical primacy of the United States, along with the unmatched sophistication and liquidity of its capital markets, means that the cash and bonds of choice in this scenario are the dollar and US Treasuries. This means that the greenback should rise if the US begins to experience a deep-enough recession to warrant fears of worldwide contagion.

Phase 2: As the pace of decline in economic activity invariably begins to slow, the markets become hopeful that the worst is over and capital begins to shift out of dollar-denominated, safe-haven assets and back toward higher-risk, higher-return investments, sending US units lower from their peak amid the crisis.

Phase 3: Finally, as the economic recovery in the United States begins to gain momentum, investors start to speculate that the Federal Reserve will need to raise interest rates (which were surely lowered amid recession) to rein in building inflationary pressure, sending the US dollar higher once again.

Broadly speaking, history seems to bear out Mr. Jen’s hypothesis. As illustrated in the chart below, data going back to 1970 shows that the US dollar Index (an average of the greenback’s value against six of its top counterparts) is higher when US gross domestic product growth rates are either sharply above or below the average of other G7 nations; and it is lower when the difference in growth rates declines, revealing a “convex” relationship, or a “smile.”

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Dollar Smile Points to USD Gains in 2010
The “dollar smile” framework seems to fit rather neatly into what we have seen in recent years after the global credit crunch and subsequent recession descended on the world economy. In 2008, the onset of the crisis brought a sharp move lower in the spectrum of risky assets, mirrored by a surge in the dollar even as the US economy broadly floundered.

If this seemed like the last gasp of life across financial markets, then 2009 was a collective sigh of relief. As central banks dropped interest rates to record lows and governments frantically doled out some $2 trillion in stimulus, the sheer panic that seized investors after the collapse of investment banking giant Lehman Brothers began to recede. Sharp declines in leading economic indicators began to slow, credit markets showed cautious signs of life, and a glimmer of hope began take root across the world’s exchanges. Having stared down a near collapse of the global financial system, investors began piling back into risky assets, sending the dollar tumbling in the process.

Looking ahead to 2010, it seems we are beginning to enter the right side of the “smile.” We find ourselves with a US economy that has put in two consecutive quarters of positive economic growth—the latest at the snappy annualized pace of 5.7%—as well as with a Federal Reserve that has been actively trimming the asset-buying portion of the monetary stimulus that was put in place amid the crisis with the promise of ending all unconventional easing measures by March. From there, the path of US interest rates leads invariably higher, leaving the door open for speculation about eventual monetary tightening to drive the US dollar upward against most major currencies.

By Ilya Spivak of

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