Welcome to Thoughts on the Market.
I'm Andrew Watrous, G10 FX strategist at Morgan Stanley.
Today a look at how the US dollar behaves under different global growth circumstances and why, contrary to the views of some observers, we think the dollar still smiles.
It's Friday, September 5th at 10 a.m. in New York.
We've been talking a good amount on this show about the US dollar, not just as a currency but as the cornerstone of the global financial system.
As the world's reserve currency, its movements ripple across markets everywhere.
The trajectory of the dollar affects everything from your portfolio's performance to the cost of your next international vacation.
Let's start with the dollar smile, which is a framework Morgan Stanley FX strategist developed back in 2001 to explain how the dollar behaves under different global growth scenarios.
Picture a smile-shaped curve.
On the left-hand side, the dollar rises, goes up when global growth is concerningly weak, as nervous investors flock to US assets as a safe haven.
On the right side of the dollar's smile.
When US growth outperforms growth in the rest of the world, capital flows into the US, boosting the dollar.
In the middle of the curve, which is the bottom of the smile.
The dollar weakens, goes down when growth is robust around the world and synchronized globally.
In that environment, middle of the smile, investors seek riskier assets, which weighs on the dollar, in part because they could borrow in dollars and invest outside the US.
Kind of a simple framework, right?
But here's the twist.
Some investors argue the left side of the smile might be broken.
In other words, they say that the dollar no longer rises if people are really worried about global growth.
They say that if the US itself is the source of the growth shock, whether it's political uncertainty or trade wars, the dollar shouldn't benefit, or that the rise in US interest rates, which makes it more expensive to borrow in the US and invest abroad, or changes in the structure of global asset holdings might mean that growth scares won't lead to an inflow to the US in a dollar bid.
We disagree with those challenges to the dollar smile framework.
To quantify the dollar smile in order to test whether it still works.
We started by using economic surprise indices.
These indices measure how actual economic data compares to forecasts.
We found that when growth in the US and outside the US are both surprisingly weak in other words, they're much weaker than forecasted the dollar rises on average about 08 per month over the last 20 years.
And then, on the right side of the dollar, smile.
When US growth really outperforms expectations, but growth outside the US underperforms expectations, the dollar goes up even more, about 11 on average per month.
And in the middle of the dollar smile.
During synchronized global growth, the dollar tends to decline on average a little bit, about 01 on average per month.
The question is, does that framework, does that pattern still hold up today?
We think it does for a few different reasons.
In 2018 and 2019, despite trade tensions and US policy uncertainty, playing a big role in driving global growth.
Concerns The dollar strengthened during periods of poor global growth.
In June 2025, when geopolitical tensions spiked between Israel and Iran and growth concerns became elevated, the dollar surged.
Investors fled to safety, and the dollar delivered.
It's true that in April 2025, the dollar dipped initially after the first tariff announcements.
But then it fell even more after those tariff hikes were paused, despite a rebound in stocks.
Growth concerns were mitigated and the dollar went down.
So this episode, I think, wasn't really a breakdown of the smile.
What weighed on the dollar of the spring was policy unpredictability in the US, which led investors to reduce their exposure to US assets, rather than concerns about global growth.
So these episodes, I think, showed the dollar can still act as a safe haven despite changing patterns of global asset ownership, the rise in US interest rates, and even when the US itself is the source of global concerns.
Now, setting aside the framework, it's important to note that the US dollar dropped about 11 against other currencies in the first half of this year.
This was the biggest decline in more than 50 years and it ended a 15-year bull cycle for the US dollar.
Moreover, we think that the dollar will continue to weaken through 2026 as the Fed cuts interest rates and policy uncertainty remains elevated.
Still, even with all that, we think our framework holds.
When markets wobble, remember this.
The dollar will probably greet volatility with a smile.
Thanks for listening.
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