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Pardon me, but let’s speak about economics here first. It’s common knowledge that the currency is likely to fall when its country’s economic outlook worsens, right?
But did you know that the USD has this interesting behavior of rising despite the US economy performing poorly? Why?
In this lesson, you’ll explore what makes that possible. Specifically, you’ll gain knowledge about the concept of the Dollar Smile theory.
In economics, we know that when the;
That’s tested. That’s proven. That’s always accurate.
But did you know that the USD is exempted to that golden economic rule? With the Dollar Smile theory, Stephen Jen pointed out the unique movement behavior of the USD.
In its most basic form, its suggests that the USD tends to appreciate against other currencies when the United States’ economy is strong or even in its weakest.
Do we call it the Dollar Smile theory because it smiles when it’s strong?
Well, that’s most of it.
Graphically, the Dollar Smile theory presented a “smile”-like shape when plotted against time or economic conditions.
The "smile" shape implies that the U.S. dollar tends to;
As the name suggests, the Domestic USD is used within the United States itself.
In this context, it represents the currency used for transactions within the countries, like buying goods and services, paying wages, or conducting financial transactions among American residents and businesses.
The domestic US dollar behaves like any other currencies in the world. It’s mainly dependent on the economic outlook and potential investment returns of the United States.
Also known as the Strong Dollar, the international US dollar is the dollar that experiences the unique economic movement. This refers to the USD that is used in internation transactions and global trade.
In this context, it represents the currency used for cross-border trade, international investments, foreign exchange reserves held by central banks of other countries, and transactions in the forex market.
In forex trading, having knowledge about the health of a currency’s economy is essential to speculate the potential market movement.
So, if you want to know the future market movement of major pairs, monitoring the USD economic outlook using the Dollar Smile Theory may benefit you.
Here are the forex market implications of the Dollar Smile Theory:
You can use the Dollar Smile Theory to forecast potential trends in the value of the U.S. dollar based on the phase of the economic cycle.
For example, during periods of economic expansion, traders may expect the USD to weaken relative to other currencies, while during economic contractions, they may anticipate a strengthening of the USD.
Monitoring and applying the signals brought by the Dollar Smile Theory can help you manage risk.
With the theory, you have a reference in anticipating potential shifts in the currency value, specifically the major pairs or pairs with USD. You can adjust your positions and strategies based on your expectations of how economic conditions impact the USD and other currencies.
The Dollar Smile Theory is part of a broader understanding of global economic trends and their impact on currency markets.
You may consider various forex market fundamentals to assess the health of the economies and their potential market movement. This includes fundamentals like the GDP growth, inflation rates, employment data, and geopolitical events.
When the American economy performs best relative to the countries around the world, its likely for the USD to strengthen and experience value appreciation compared to all currencies.
When the financial market, like forex market, are crashing or being disorder, the market sentiment is likely to switch to risk-off. Risk-off is basically a market sentiment where traders reduce their risk exposure to protect their capital.
Once the forex market experience disturbance, the traders will rush to USD because of its safe-haven status. With this, the USD market will rally due to increased buying pressure.