This article is a rewritten and expanded version of the original analysis titled “USD: The Dollar Smile is Back; Risks to Remain Skewed to the Upside – Morgan Stanley,” as published by the team at eFXdata. The original article can be found at eFXdata.com. Credit for the core insights and forecasts goes to the Morgan Stanley Global FX Strategy Team, as referenced in the eFXdata publication.
Title: The Dollar Smile Returns: Morgan Stanley Projects Further Upside for the US Dollar
Introduction
Global currency markets are entering a new phase as a variety of macroeconomic and policy factors converge. Among major currencies, the US dollar (USD) is developing renewed strength, bolstered by what Morgan Stanley refers to as the return of the “Dollar Smile.” According to Morgan Stanley’s Global FX Strategy Team, despite recent dollar strength and mildly stretched valuations, multiple catalysts are aligning to keep risks skewed to further upside in the near to medium term. Below is an in-depth look at Morgan Stanley’s analysis and expectations for the USD trajectory.
Overview of the Dollar Smile Framework
The “Dollar Smile” is a widely recognized concept in FX strategy circles. It describes the behavior of the USD along various stages of global economic performance. The smile-shaped model shows the dollar appreciating under two extreme scenarios:
– On the left side of the smile, the USD strengthens when global growth is weak or recessionary, due to the safe-haven appeal of the dollar.
– In the middle of the smile, when global growth is moderate and risk appetite is healthy, the dollar tends to weaken as capital flows into higher-yielding and riskier assets.
– On the right side of the smile, the USD rallies again when US growth is exceptional and outpaces other economies, particularly coupled with expectations of tighter monetary policy.
Morgan Stanley now asserts that the USD is being supported by the right side of the smile — driven by robust US economic performance and increasingly hawkish expectations regarding Federal Reserve policy.
Key Drivers Supporting USD Strength
Morgan Stanley outlines several macroeconomic and policy-related factors currently reinforcing the upside case for the dollar:
1. Exceptional US Economic Resilience
– Despite global growth concerns and slowing demand in major regions such as the Eurozone and China, the US economy continues to show resilience in consumer spending, job creation, and services sector activity.
– Quarter-on-quarter GDP growth remains firm in the United States, standing in contrast to stagnation or contraction in other developed markets.
– With inflation moderating at a slower pace, the US economy’s ability to tolerate higher real interest rates sets it apart from peers.
2. Market Repricing of Fed Policy
– After earlier expectations for Federal Reserve rate cuts, markets have recently shifted to recalibrating for a prolonged pause or even a potential hike.
– Fed messaging remains cautious given sticky services inflation and tight labor markets.
– As a result, real yields in the United States continue to trend higher, boosting the appeal of US-denominated assets.
3. Divergent Monetary Policy Outlooks
– While the Fed may hold or increase rates, central banks in other economies are moving in the opposite direction.
– The European Central Bank (ECB) and the Bank of England (BoE) face increasing pressure to ease policy as inflation in their respective regions falls more sharply and growth shows clear signs of fatigue.
– The Bank of Japan (BoJ) is only starting to normalize after decades of ultra-loose monetary policy, and real yields in Japan remain deeply negative.
– This divergence is supportive of the USD against not just the euro and pound, but also the Japanese yen and a broader basket of currencies.
4. Safe-Haven Demand Amid Global Uncertainties
– Rising geopolitical tensions in Eastern Europe and the Middle East have reinforced the dollar’s traditional role as a safe-haven asset.
– Risk-off sentiment triggered by financial instability or political uncertainty also feeds demand for US Treasuries and, by extension, the USD.
5. Capital Flow Momentum Toward
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