Market Commentary
The Da Da Da Dollar
I once had a sales assistant that had a minor speech impediment which sometimes manifested itself in a stutter, among other things. He was a talented hard-working kid, and I believe he is now making buckets of cash at a large hedge fund in Connecticut.
Like my former assistant, participants are having their own stutter episode as they conflate current USD cyclical weakness for a secular change in the currency’s reserve status.
The error is an easy one, as trade wars and a mafia-like diplomatic approach make for great narratives. In any event, if such a thing would happen it would be a process that would play out over time, mainly due to TINA – there is no alternative.
No other currency is as deep and liquid as the USD to transact in the $7 trillion daily currency market.
China has a closed capital account.
Europe is half-pregnant with an incomplete currency because there is no federalized budget that would allow for pan-European bond issuance for the entire Eurozone area, as opposed to current single-sovereign issuance.
There is a whole literature devoted to this space, which will not be summarized here for fear of getting a mind-numbing headache. For now, we will stick with U.S. Treasury Secretary John Connally’s dictum that the U.S. dollar is “our currency but it’s your problem”.
The first step in contextualizing the current dollar move is to look what it has done through time in various cycles.
The first thing that stands out is that the dollar tends to appreciate as a crisis is brewing and it becomes the safe-haven asset of choice.
The second thing that stands out is that when ex-U.S. global growth is stronger than the U.S., the dollar underperforms other currencies.
Finally, when the U.S. growth is stronger, the dollar outperforms.
This strong-weak-strong dynamic was christened the dollar smile theory by Stephen Jen, Morgan Stanley’s foreign exchange strategist from around 20-years ago.
What is currently confusing observers is that the dollar has sold off since peaking in mid-January, despite rising geopolitical tensions due to President Trump’s trade war. This sell-off amid crisis has given rise to the idea of the dollar being abandoned and losing its safe-haven status.
Under the dollar smile framework, that is not an unreasonable conclusion. This framework, however, is likely outdated.