The evolution of the dollar smile

The dollar smile has been a textbook framework for foreign exchange (FX) investors for a considerable period. When global growth is strong – the middle of the smile – the dollar tends to underperform other currencies, while in times of US outperformance or during a global recession, the US dollar is your friend. However, we’ve argued for some time that the dollar may no longer be a safe haven in times of distress.

We think this framework is out of date due to the huge shift in portfolio flows and portfolio hedging behaviour since the Global Financial Crisis (GFC). In the current economic landscape, a recession that causes a major correction in asset prices and leads to Federal Reserve (Fed) rate cuts presents an opportunity to sell US dollars aggressively.

Given the rising odds of a US recession, we wanted to highlight areas where this dislocation from the traditional dollar smile might already be playing out:

• The net international investor position in the US has deteriorated markedly since 2008. Within portfolio investment, this has almost entirely been driven by the net equity position which has fallen from c.10% of GDP to close to -10% as both domestic and international investors have piled into the US equity growth story. In previous recessions, US capital in risk assets would be repatriated back home, strengthening the dollar. Today, given the net position, we believe capital will instead be going back to international markets such as Taiwan, Japan and Korea, if US equities were to correct and if the Fed reduces the yield on US Treasuries in the event of a recession. Money has also followed performance, so if the current popular trade into US tech was to unwind,  this dynamic could  be amplified.
  

• The capital that has arrived in the US is largely unhedged. Consider an American buying TSMC and Taiwanese investor buying Nvidia. As funding costs in the US have risen, the cost of hedging your US asset back into Taiwanese dollars (TWD) has been prohibitive for the Taiwanese investor. It’s been cheaper not to hedge and it’s been a great trade as the US dollar has rallied. Now consider the reverse of this – a US investor allocating to TSMC, for example, probably hedges this back into USD to avoid paying away the high yield on his or her US dollars, or because they don’t have a view on the TWD. This creates two vulnerabilities for the US dollar:
  
      a. If there is a period of risk aversion and investors unwind their portfolios, the Taiwanese investor may sell Nvidia and close their currency risk – this is negative for the USD. Conversely, the US investor may sell TSMC that was hedged back to USD and bring their USD home – resulting in no direct impact on currency.
  
      b. The second vulnerability is that, in a recession, the Fed lowers interest rates significantly. The Taiwanese investor has more incentive to hedge their Nvidia back into Taiwanese dollars as costs fall. The US investor has more incentive to leave their TSMC stock unhedged as interest rates converge. The recent drawdown in early August was a fascinating test case for this. As global equities cratered, the TWD actually put in a small rally. The Taiwan Stock Exchange fell over 10% and is very tech heavy, yet the impact on the currency was positive as the market priced in Fed cuts and investors reduced risk.
• Bonds have been an awful hedge for risk in a period of high inflation. Your only hedge has been the US dollar. As inflation falls, the Fed can cut rates in a global downturn limiting the attractiveness of the US dollar. We’ve seen tentative signs that these correlations are turning.

• Our previous point on USD funding stress is also validated by recent price action. Measures are in place to provide US dollars in times of crisis through standing swap lines between major central banks and the Fed, and so too is a precedent to establish swap lines with smaller central banks in the event of funding stress. So, while crises in the past have seen a sharp spike in dollar demand, in the future this demand should be met with ample supply, thus limiting dollar appreciation. In the recent market stress in August, cross-currency basis was generally well-behaved.
• Another key difference is the dynamics of the carry trade. In previous cycles, US interest rates were often lower than other countries, and investors could borrow more cheaply in the US than elsewhere, meaning the USD was frequently a funder in the carry trade. Today, global savings outside of the US are much higher, keeping borrowing costs elsewhere relatively lower, while strong US growth has seen US interest rates rise. In a scenario where investors look to reduce risk, the trade will be to buy low-yielding currencies like the Japanese yen and Swiss franc – and to sell the dollar.

In a traditional US dollar smile framework, the greenback outperforms when global recession fears are rising (the left-hand side) or when the US economy is outperforming its global peers (the right-hand side). In our framework, we believe that capital flows since the Global Financial Crisis and the current high cost of hedging USD assets for non-US investors would see the USD weaken in a “left-hand side” scenario. We therefore believe the new US dollar smile resembles more of a smirk.