We remain structurally and cyclically positive on the dollar and believe that the weakness experienced by the dollar since May 2020 will likely prove to be transitory. In this note, we update our call, incorporating the recent data and events, and underscore some key thoughts we have on the dollar.

1. The dollar is not just a safe haven currency like the Japanese yen or the Swiss franc with a monotonic relationship with risk; the dollar’s relationship with risk is non-monotonic. The dollar is the hegemonic international currency in the world that has remained popular for capital transactions despite the fact that the market share of the US economy as a proportion of the world’s economy has steadily shrunk for two decades. At the same time, for much of the time since 2000, significant economic out-performance of the US relative to the G10 economies have meant a stronger dollar. No other currency in the world possesses this non-monotonic trait with risk. Few would dispute that we are indeed entering that phase of significant US economic outperformance vis-à-vis the rest of developed markets (DM). If our Dollar Smile framework is still valid, the dollar should reassert itself in the coming quarters.
2. Many of the reported relationships between the different moments of the US yield curve (nominal level, real level, the curvature, the steepness, the direction of the movement on the yield curve, and the speed of this movement) and the dollar are, in our view, spurious, and have not been reliable since the global financial crisis (GFC) in 2008. In fact, the very reason why most of the quant FX funds are no longer in business is precisely because of the loss in predictive power of the yield curve for currencies. If the analysts are right with their recent declarations of statistical relationships between bits of the US yields and the dollar, they either have made extraordinary discoveries that have evaded fund managers, or such relationships are spurious and not robust. We suspect it is the latter. What this means is that the forecast for currencies ought to be based on logic and macro analysis rather than spurious empirics.
3. Another critical question, in thinking about the impact of the US fiscal stimulus, is that such a positive demand shock may, a priori, be inflationary, but ex post, may not be, as the excess demand is either unspent or met through imports. The large US current account (C/A) deficit resulting from the fiscal stimulus will likely become a factor driving the dollar. But we believe the capital flows supporting USD assets will be sufficiently large to overwhelm the usual worries associated with a wide C/A deficit.

The full report contains the following sections:

• The Dollar Smile framework is likely to still work well
• Spurious relationships between the yield curve and the dollar
• A prospective sharp widening in the US C/A deficit and the dollar
• Belly of the distribution and tails
• Example 1. The US in the 1980s
• Example 2. German reunification in the early-1990s
• The long-run effects on the dollar may not be that positive, though
• Bottom line

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