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Ever wonder why the U.S. dollar strengthens both in times of tough luck and when the economy is booming like a Beyoncé single?

Well, so does everybody else. In fact, this really smart dude over at Morgan Stanley came up with a theory to explain this phenomenon.

Stephen Jen, a former currency strategist and economist, came up with a theory and named it the “Dollar Smile Theory.”

The Dollar Smile Theory Explained

His theory depicts three main scenarios directing the behavior of the U.S. dollar. Here’s a simple illustration:

The Dollar Smile Theory

Scenario #1: USD Strengthens Due to Risk Aversion

The Dollar Smile Theory: PanicThe first part of the smile shows the U.S. dollar benefiting from risk aversion, which causes investors to flee to “safe haven” currencies like the U.S. dollar and the Japanese yen.

Since investors think that the global economic situation is shaky, they are hesitant to pursue risky assets and would rather buy up  “safer” assets like U.S. government debt (“U.S. Treasuries”) regardless of the condition of the U.S. economy.

In order to buy U.S. Treasuries though, you need USD, so this increased demand for USD (to buy U.S. Treasuries) causes the U.S. dollar to strengthen.

Scenario #2: USD Weakens to New Low Due to Weak Economy

The Dollar Smile Theory: Dollar bull falling off a cliffDollar drops to a new low.

The bottom part of the smile reflects the lackluster performance of the Greenback as the U.S. economy grapples with weak economic fundamentals.

The possibility of interest rate cuts also weighs the U.S. dollar down. (Although if other countries are also expected to cut interest rates, then this might be less of a factor since it’s all about expectations of the future direction of  interest rest differentials.)

This leads to the market shying away from the dollar. The motto for USD becomes “Sell! Sell! Sell!”

Another factor is the relative economic performance between the U.S. and other countries. The U.S. economy may not necessarily be horrible, but if its economic growth is weaker than other countries, then investors will prefer to sell their U.S. dollars and buy the currency of the country with the stronger economy.

It’s kind of like if you owned an NBA team and had Reggie Miller as your star player. All of a sudden, a healthy Michael Jordan is available. Obviously, you would trade Miller for Jordan because, on a relative basis, Jordan is the better performing player.

It’s not that Reggie Miller sucks, but there’s just a better alternative at that moment. Now if you make the trade, and all of a sudden, Michael Jordan has a season-ending injury, and Reggie Miller just so happens to be available, then you know what to do.

Dump “Air Jordan” for “Miller Time”. See, it’s all relative.

Scenario #3: USD Strengthens Due to Economic Growth

The Dollar Smile Theory: Dollar bull marketThe dollar appreciates due to economic growth.

Lastly, a smile begins to form as the U.S. economy sees the light at the end of the tunnel.

As optimism picks up and signs of economic recovery appear, sentiment towards the dollar begins to pick up.

In other words, the Greenback begins to appreciate as the U.S. economy enjoys stronger GDP growth, and expectations of interest rate hikes increase (relative to other countries).

This theory appears to have been in play when the Great Financial Crisis (GFC) began.

Remember when the dollar got a huge boost at the peak of the global recession?

That’s phase 1.

When the market eventually bottomed out in March 2009, investors suddenly switched back to the higher-yielding currencies, making the dollar the winner of the “Worst Currency” award for 2009.

That’s phase 2.

GDP percent chang vs U.S. Dollar Index

So will the Dollar Smile Theory hold true?

Only time will tell.

In any case, this is an important theory to keep in mind. Remember, all economies are cyclical.

The key part is determining which part of the cycle the economy is in.