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

Currencies tend to fall when their country’s domestic outlook worsens, but the U.S. dollar’s unique global role makes it special so when the U.S. economy isn’t doing great, the currency may still rise.

A helpful to look at why this is the case is to pretend there are two “types” of U.S. dollars.

1. There is a “domestic” U.S. dollar that behaves like any other currency. It’s linked to the economy’s relative outlook and potential investment returns.

2. There is also an “international” U.S. dollar that is used as the primary currency used in global trade (for payments) and also needed to buy U.S. government bonds which are coveted for their safety.

This “international” U.S. dollar strengthens for a variety of reasons when markets are volatile and global growth slows.

When there is some sort of “shock” that happens, whether from the U.S. or abroad, and it’s big enough to cause investors and traders to panic and send financial markets lower, then it will likely cause the broad U.S. dollar to appreciate

In fact, this really smart dude who used to work at Morgan Stanley came up with a theory to explain this phenomenon.

Stephen Jen, a former economist at the International Monetary Fund and Morgan Stanley, who now runs a hedge fund and advisory firm Eurizon SLJ Capital in London, 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:

Scenario #1: USD Strengthens Due to Risk Aversion

The 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

Dollar 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 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).

Let’s take a look at the Dollar Smile Theory in reality…

As you can see, due to the global pandemic which has caused a lot of economies all over the world to suffer, the U.S. dollar is acting as a safe haven currency. All countries, including the U.S., aren’t doing so great.

But if the economies from the “rest of the world” (RoW) can improve and start to grow faster than the U.S. economy, then expect the U.S. dollar to weaken.

The key is relative economic growth. If growth from other countries is growing, but the U.S. economy is growing even faster, then the U.S. dollar will swing upward to the right side.

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. They strengthen, then they weaken, they strengthen, then they weaken, and repeat.

The key part is determining which part of the cycle the U.S. economy and then compare how it’s doing against the rest of the world (RoW).