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Monday, January 28, 2008

The Dollar Smile Theory

Morgan Stanley: Economic Re-Coupling Will Boost the Dollar Smile in 2008: “The dollar’s general weakness so far in 2008 gives little support to the 'Dollar Smile' theory. But according to Stephen Jen, Luca Bindelli and Charles St-Arnaud in the Global Economic Forum, Morgan Stanley believes that the Dollar Smile will eventually work, admittedly with a delay.

As opinions among investors change - particularly those on the U.S.'s slowdown being felt primarily in the U.S., and also the low yield premium on USD assets - Morgan Stanley foresees the following effects on the dollar:

"... [a] rally this year against the EUR and the GBP. In turn, the JPY and CHF could rally against the strengthening dollar, for as long as the U.S. is in a recession, which we believe will likely persist through 1H08. One by one, various parts of the rest of the world will start to show signs of a slowdown/deceleration. Even though we are of the view that this ‘economic re-coupling’ will be tentative and partial, financial coupling will likely push investors back into ‘fear mode’ and bond rather than equity flows will, perversely, support the dollar – consistent with our ‘Dollar Smile’ framework.”

All of this is of course based on the assumption that the world’s economies never really de-coupled in the first place… I’ve posted about de-coupling on December 12, 2007: The Global Decoupling Theory is Garbage. On December 17th, 2007 I presented additional data and charts in Asia Tanks.

MacroMan tackles the Dollar Smile theory in his January 7th, 2008 post: Will A US Recession Strengthen The Dollar:

“One possible explanation is an emerging school of thought that a US recession/quasi-recession is actually good for the dollar. According to the proponents of this theory, weak/negative US growth is both damaging to the rest of the world and a catalyst to encourage US investors to bring money back home. The upshot is that there is less demand for foreign assets/currencies and more demand for US assets/currency; hence, the dollar rallies.”

I don't need to tell you what this would mean for commodities and the commodity Bull eh?

Gold, oil? Can you say, "Body Slam?"

19 comments:

Anonymous said...

I agree that these elements are dollar positive, however, with the Fed taking on Toxic asset garbage from the banks through the TAF and the ever increasing Federal deficit which we eventually our foreign neighbors will not be able to support or cant support. Eventually it is going to be race race to the bottom for all currencies as each country fires up the printing presses in an attempt to recover from the Decession of 2008. You also better beleive that the Fed would much rather inflate its way out of that huge federal debt rather than let it grow (i.e. negative inflation rate).

Cheers

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