What is the dollar smile theory, and is it still valid today?

The “dollar smile” is an economic theory that describes the
behavior of the U.S. dollar in different phases of the economic cycle. It
suggests that the dollar strengthens during periods of strong economic growth
(when investors become optimistic and buy U.S. assets) and during recessions
(when investors flee for safety). However, it tends to weaken when the U.S.
economy is growing moderately.

So what could the drop in
the dollar index in recent months indicate?

Following the logic of the “smile” theory, the
U.S. economy could be in the middle phase of the curve — a period of moderate
growth when investors are neither chasing high-risk assets nor retreating to
safe havens. But in reality, the dollar’s recent weakness seems less to do with
sluggish growth and more with rising concerns over the ballooning national
debt, which recently topped $36 trillion.

Yes, tariff revenues are up: the U.S. has collected $67.3
billion from tariffs through May 22, up 76.9% from the same period last year.
However, if the proposed tax bill, which would make permanent the individual
income and estate tax cuts from Trump’s 2017 legislation, goes through, it
could add as much as $3.8 trillion to the national debt over the next decade.
No wonder Moody’s
downgraded the U.S. credit rating.

Another factor weighing on the dollar is the global shift
away from the greenback amid escalating trade tensions. For example, China’s
central bank has raised the yuan’s minimum participation in cross-border
transactions from 25% to 40%, while ECB President Christine Lagarde stated that
the euro could become a viable rival to the dollar if the EU succeeds in
strengthening its financial and security architecture.

Finally, it’s worth noting that Donald Trump has made it
clear during his campaign that he supports a weaker dollar to help boost U.S.
exports. The problem is that when a falling dollar is combined with the impact
of tariffs, it can fuel inflation. That’s precisely what Fed officials are
worried about, so they’ve stuck to a hawkish stance in recent weeks, signaling
that a rate cut may not happen until September.

So what lies ahead for the dollar?

Much depends on how trade negotiations evolve. The dollar
could regain some strength if the current pause in tariff escalation against
China and Europe translates into concrete agreements. There is even speculation
that Trump may consider tying tariffs to foreign purchases of U.S. debt. If
that happens, we could see the
EUR/USD pair move towards the 1.20 level, although it remains to be
seen if that scenario comes to life.