2020-03-31 2020-03-31 Did Dollar Set a Trap? 31.03.2020 Dmitri Demidenko 2020-03-312020-03-31

According to the dollar smile theory, the USD decline is just a correction

Unlike the past recessions, the current downturn doesn’t result from the unwillingness of consumers and companies to spend. They simply can’t spend. It is rather like a hurricane that hits a particular territory and seriously harms the region’s economy. The economy follows with a quick recovery amid dealing with disaster’s fallout. The coronavirus has spread all over the world affecting the global economy for at least a few months ahead. The longer the pandemic will last, the more chances are that the temporary difficulties will turn into long-term problems.

A typical example is China that is about to announce the victory over the epidemic. China’s manufacturing PMI has been up from 35.7 to 52 in March. The value above 50 indicates expansion. The Chinese economy is recovering, but the PBOC continues cutting the rates to support the demand that is still pressed down by the coronavirus. The People's Bank of China reduced the interest rate on 7-day reverse repurchase agreements to 2.2% from 2.4% when it injected 50 billion yuan ($7.1 billion) into the banking system. Unlike the Fed, the Chinese central bank can afford it, there is room for further rate cuts.

Dynamics of China’s PMIs

Source: Bloomberg

Dynamics of PBOC interest rates

Source: Bloomberg

The USA is far from winning over the pandemic, but the US stock indexes are behaving as if the hurricane were in the past. The recession is going to be deep but short. What if it isn’t so? What if the scenario of 2008, when it took the US economy years to recover, is going to play? According to the former Fed chief, Janet Yellen, the excessive assistance to the corporate sector is a bad choice. Companies are already given a lot of loans, they can use cheap money to buy back shares or pay dividends. High debt loads, abetted by low rates, could trigger a wave of corporate defaults and cutbacks, which is likely to make it harder for the economy to recover from the coronavirus crisis.

Looking back at the events of 2008, due to the high demand for safe-haven assets, the US dollar was 24% up in the period from March through November. The Fed’s rate cut and the launch of the QE worth $700 billion dampened the dollar rate a little by December. Nonetheless, the USD index was up by another 15% through March 2009. If the uncertainty around a recession goes on, investors instinctively buy the dollars. Such movements of dollar rates correspond to the dollar smile theory. The USD rally is followed by a drop to the bottom amid the Fed’s aggressive monetary easing. However, after hitting the low the US dollar starts rising again, as investors believe that the US economy will recover quicker than the global GDP.

In my opinion, the dollar smile theory has a flaw. In 2020, the global GDP, due to China, can start growing faster than the US economy. After all, investors are too far in buying the US stocks, as they believe the US domestic data won’t be so bad as it was expected (the time to fear is yet to come), and the S&P 500 uptrend is strong enough to withstand it. The demand for the greenback may surge again, which suggests the relevance of selling the EUR/USD if the supports at 1.087 and 1.084 are broken out. However, before the dollar’s rally continues, the pair may be consolidating for some time.

P.S. Did you like my article? Share it in social networks: it will be the best “thank you" :)

Ask me questions and comment below. I’ll be glad to answer your questions and give necessary explanations.

Useful links:

I recommend trying to trade with a reliable broker here. The system allows you to trade by yourself or copy successful traders from all across the globe.

Use my promo-code BLOG for getting deposit bonus 50% on LiteForex platform. Just enter this code in the appropriate field while depositing your trading account.

Telegram chat for traders: https://t.me/liteforexengchat. We are sharing the signals and trading experience

Telegram channel with high-quality analytics, Forex reviews, training articles, and other useful things for traders https://t.me/liteforex

Price chart of EURUSD in real time mode

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.