Lecture Notes: The "Dollar Smile" Theory

Key Concepts

• Dollar Smile Theory: Suggests that the U.S. dollar gains strength during two conditions:
  • When the U.S. economy is healthy.
  • During global economic shocks.
  • The dollar weakens when the U.S. economy is weaker relative to the world.

Current Economic Context

• Dollar Highs:

  • The dollar is at its highest value since the early 2000s.
  • Fueled by the U.S. Federal Reserve's interest rate hikes and global economic concerns.

• Unexpected Surge:

  • Typically, such increases occur gradually over 2-3 years.
  • Currently, it is an unexpected, rapid increase.

Global Impact

• Reserve Currency

  • The U.S. dollar is a dominant global reserve currency.
  • $7 trillion held by 149 countries.

• Investor Attraction

  • Stability due to proactive U.S. central bank interventions.
  • Demand influenced by the U.S. economic state.

• Greed Mode vs. Fear Mode

  • Greed Mode: Strong economy, higher returns attract investors.
  • Fear Mode: Economic struggle, dollar seen as a secure asset.

Current Global Economic Issues

• Factors Driving Dollar Strength:

  • Volatile financial markets.
  • Global economic growth fears.
  • Supply chain disruptions (e.g., China's COVID response).
  • European energy crisis and global inflation.

• Impact on Other Currencies:

  • Strong dollar weakens other currencies (e.g., dollar-euro parity).
  • Strain on global economies, especially emerging markets.

Consequences of a Strong Dollar

• For Global Economy:

  • Inflation Export: Strong dollar raises prices in emerging markets.
  • U.S. goods become more expensive overseas.

• For U.S. Economy:

  • Cheaper imports lower domestic prices.
  • Negative impact on U.S. exporters' profits.
  • Examples: Microsoft, Salesforce, Coca-Cola report losses due to strong dollar.

Economic Outlook

• Potential Stabilization:

  • Requires cooling inflation, reduced geopolitical tension, and global economic recovery.
  • A stable global economy would end the "dollar smile."

• Analysts' Views:

  • A strong dollar acts similarly to a rate hike, cooling the economy but can be damaging if too strong.
  • The dollar may stabilize later this year, but timing is uncertain.