The “dollar Smile” does not favor Emerging Markets

The U.S. dollar’s recent surge against both developed and emerging market currencies has extended the current dollar upcycle into its tenth year. Since the end of the Bretton Woods gold-anchored monetary system in 1971, the dollar’s viability as a fiat reserve currency  has relied on the credibility of the Federal Reserve and the willingness of foreigners to own U.S. assets. Since 1971, a relatively predictable 16-18 year cycle has occurred, with 8-9 years of dollar strength followed by 8-9 years of dollar weakness.

Given the short life of the current dollar fiat-global reserve currency system and its absolute uniqueness in historical terms,   it is difficult to generalize and define trends. However, we can say that we are currently in a third upcycle for the USD in what appears to be a declining trend. This is highlighted in the charts below. The second chart details the current dollar upcycle, which started in early 2011. The current upcycle is now in its eleventh year, and, with the recent surge of the DXY to the 103 level, we are now at the long-term downward sloping trendline. We are currently seeing a triple top for the DXY as it has returned to peaks previously reached in 2017 and 2020.

The prolongation of the current dollar upcycle  may have several explanations. Both in 2017 and in 2020 the dollar experienced significant weakness which seemed to indicate the beginning of a downtrend. However, both these downtrends were aborted by market -shaking events that drove investors into U.S. assets: In 2017-2018, Brexit, the Trump tax cut and the  Powell pivot from hawk to dove; in 2021, the extraordinary combination of U.S. fiscal and monetary stimulus and surprisingly strong U.S. economy. Furthermore, the 2017-2022 period has been marked by the strong returns of U.S. equity markets driven by the phenomenal operational performance during the pandemic of America’s “winner-take-all” tech hegemons. Finally, the Russian invasion of Ukraine and China’s economic problems (bursting of the real estate bubble and mismanagement of COVID) have accentuated flows into  U.S. safe haven assets, mainly stocks and real estate.

The current strength of the dollar relies on the notion of American exceptionalism. The U.S. goes through periods of “exceptionalism” and “malaise” which have influence on investor appetite for U.S. dollar assets and set the course for the dollar. Despite all of its stark deficiencies, relative to the rest of the world today the U.S. looks very stable and attractive for investors and it is sucking up excess capital which drives dollar strength.

The chart below schematically describes a framework for understanding the drivers of the U.S. dollar. This so-called “Dollar Smile” framework , which is built on the insights of macro traders like George Soros and others, pinpoints how the dollar behaves in diverse economic environments.

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At the two corners of the mouth, conditions exist for a strong dollar. The right corner represents periods of U.S. exceptionalism when the U.S. leads the world in economic growth and attracts global savings. The left corner represents periods of global crisis when capital flows to the safety of financial havens, especially the U.S. with its large and liquid capital market. The current dollar upcycle over the past eleven years has been supported by one or both  corners of the smile at different times.

At the bottom of the smile, conditions exist for a weak dollar. These are periods of synchronized global growth when the rest of the world is relatively stronger than the U.S. and is attracting capital (e.g. the 1970s in Europe and developed Asia; emerging markets, 2000-2012).

At the present time, the dollar is supported by high levels of economic uncertainty arising from geostrategic conflict and the consequences of an extended period of global fiscal and monetary adventurism. The left corner of the smile is likely to dominate currency movements for the foreseeable future, which portends a strong dollar. Under these conditions, emerging market countries will continue to see persistent capital flight and their assets are not likely to offer attractive returns.