Mizuho Chart Speak – FX Update: Unpicking the USD Smile

Vishnu Varathan, Head, Economics & Strategy, Asia & Oceania Treasury Department, Mizuho Bank, Ltd.,

“I love those who can smile in trouble …” – Leonardo da Vinci

‘USD Smile’ Inflection?

Leonardo da Vinci loved those who could smile in trouble; whereas when, and how, the USD “smiles” can be trouble. As USD reaction to market sentiments gets harder to predict, the elephant in the room is whether ‘USD Smile’ mechanics is on the cusp of inflecting from “Left-Side”, that is, rising (falling) on “bad news” (“good news”), to ‘Right-Side”, which corresponds to USD rising in tandem with improving sentiments.

Trouble is, determining an inflection is challenged by USD fluid contextual shifts between the two halves, rather than being strictly confined to just one side of the ‘USD Smile’. Nonetheless, the ‘USD Smile’ is useful as a framework for determining the dominant influence on USD; between safe-haven “RORO” (“risk on-risk off”) moves, where USD moves inversely with yields, and yield-driven reactions that lift USD along with UST yields.

The ‘USD Smile’ Paradigm

To be sure, the ‘USD Smile’ proposition is a useful and more holistic framework to think about wider mechanics of USD as it encompasses aspects of, but is not limited to, “RORO” (“risk on-risk off”) as well as yield-driven USD moves; two diametrically opposed mechanics (see “RORO”-Yield Spread Schematic overleaf). “RORO” USD moves are premised on safe-haven properties of the USD, which means a stronger (weaker) USD corresponds to worsening (improving) sentiments; and likely lower (higher) UST yields. This is the exact opposite of yield-driven USD mechanics whereby higher (lower) yield, alongside improving (deteriorating) sentiments, result in a stronger (weaker) USD.

In reconciling the two mechanics, ‘USD Smile’ proposes a U-shaped USD reaction function, with the left half corresponding to “RORO”-like USD strength based on safe-have features while the while the right-side of the ‘USD Smile’ squares with USD strength on rising yields in the context of improving sentiments/economic prospects.

Pinning Down ‘USD Smile’ Curve Position Useful …

So figuring out at which point of the ‘USD Smile’ curve current FX markets are functioning could be a very useful in anticipating FX market reactions to headline events and economic outcomes. But empirical evidence suggests that the ‘USD Smile’ is not a rigid rule for the USD, but rather a fluid framework within which USD can operate with a good degree of discretion, depending on circumstances.

Specifically, correlations between USD moves and changes in risk sentiments (using S&P500 volatility index, VIX as a proxy) reveal that historically the USD is far more ambidextrous, shifting quite easily between the “Left-Side” and the “Right-Side” of the ‘USD Smile’ than a static application of the ‘USD Smile’ framework might lead one to believe. Moreover, and more pertinently, that the ‘USD Smile’ mechanics is currently more ambiguous in, with correlations suggesting no strong bias one way or another (between “RORO” and yield-driven moves).

This is understandable given that on one hand an exceptionally accommodative Fed, with an unprecedented easing bias and paradigm shift to allow the economy to “run hot” alongside lingering uncertainty amid virus-vaccine tensions suggest “RORO” type of USD mechanics (“Left-Side” of ‘USD Smile’) will dominate. Whereas on the other, reflation in the context of the US leading the way out in global economic recovery (helped by its vaccine rollout gains and fiscal stimulus) may predispose FX markets to tilt the balance to yield-driven USD moves (“Right-Side of ‘USD Smile’). In turn, this suggests that how UST yields evolve in the context of the vaccine rollout and exceptional US fiscal stimulus ($1.9trln in COVID relief with US$3trln in infrastructure planned) and the Fed’s reaction function to corresponding economic outcomes.

Yielding to the Policy Card?

On that note, rising UST yields, especially if reinforced by rising real yields, is arguably a key motivation for ‘USD Smile’ dynamics to shift to the “Right Side”. But only inconclusively so. Instead, experience suggests that Fed policy shift (e.g. 2013 “taper) shift tends to be a more decisive catalyst in entrenching a shift from “Left-Side” to “Right-Side” of ‘USD Smile’. With the Fed bent on batting away suggestions of foreseeable normalization, an emphatic ‘USD Smile’ inflection eludes. Meanwhile, amid opposing factors favouring “Left-Side” (Fed bias, uncertainty, etc.) and “Right-Side” (rising UST yields, US leading the recovery, etc.), ‘USD Smile’ dynamics are more likely to oscillate more easily between the two halves.

EM Asia FX: Volatile Differentiation?

This ‘USD Smile’ curve variability necessarily entails higher downside volatility as well as a greater degree of differentiation within EM Asia FX; which have been factored into H1 forecasts. At least until markets get a grip on the transmission from the Fed’s flexible average inflation target (which anchors low end yields exceptionally well) to long-end yields, EM Asia FX may be subject to volatility, vulnerable to episodes of USD strength. Differentiation within EM Asia FX may then be coloured by differences in vaccine rollout, exposures to higher energy/commodity/food prices and supply-chain positioning in tis uneven global demand recovery. Typically, an unexpectedly stronger USD from ‘USD Smile’ inflection will tend to impact “twin deficit” and higher-yielding EM Asia FX more adversely; but subject to the lags between UST yield transmission and yield-seeking we outlined in an earlier piece (Mizuho Chart Speak – EM Asia Risks: Beware High-Yield Spill-over from UST Upheaval, 12th March 2021).

Source: Mizuho Bank Ltd