Dollar wins in nearly every scenario

All roads lead to a stronger dollar. That’s the view of Stephen Jen, cofounder of the hedge fund SLJ Macro Partners, who spent 13 years at Morgan Stanley where he helped develop a theory known as the “dollar smile”.

He’s predicting gains versus emerging-market currencies in particular, whether or not the US Federal Reserve succeeds in raising interest rates without sparking market turbulence.

“What we have now is a very strange situation where the US economy continues to grow but there’s elevated risk of a financial selloff, and it’s actually the most positive environment for the dollar,” London-based Jen said last week. “The dollar should be supported in multiple scenarios.”

Investors who bought the currency to speculate that the Fed would tighten policy are seeing gains even as markets push back bets on when rates will rise. The dollar has surged against the currencies of commodity producers and developing nations since the Aug 11 devaluation of China’s yuan fuelled concern that growth in the world’s second-largest economy was slowing.

Analysts predict the dollar will appreciate against more than half of its 16 most-traded peers by year-end.

Meanwhile, hedge funds are betting that the greenback will gain against emerging-market currencies, said Sam Diedrich of Pacific Alternative Asset Management Co, which oversees $9.5 billion in hedge-fund investments. “There are a lot of reasons to think that US dollar strength will continue for quite some time, particularly against emerging markets,” he said.

The “dollar smile” theory is based on a chart that predicts gains when the US economy is growing strongly or in a deep slump.

While the dollar weakened in 2004 when the Fed started its last cycle of rate increases, it climbed 8.7% against major peers the following year as the central bank lifted its benchmark by 2 percentage points. It surged again in 2008, with the Bloomberg Dollar Spot Index gaining 8.9%, as the global financial crisis drove demand for safe-haven assets. The index is up 7.1% this year.

The US now has the lowest jobless rate in seven years but that doesn’t mean the Fed will lift its rate this coming Thursday, as equity and currency market turmoil is also affecting sentiment.

The probability of a rate increase this week dropped to 28% late last week, based on surveys of analysts, from 54% a month earlier.

“The market will only delay a Fed-hike expectation rather than take it off the table,” said Mitul Kotecha of Barclays in Singapore. “We don’t see much respite for Asian currencies, not only are there pressures from China but at the same time there’s continued outflow of capital and slowing economic growth.”