On EM FX and the 'dollar smile' – am I misunderstanding something fundamental?
Hey folks, I'm trying to wrap my head around the 'dollar smile' theory, specifically how it applies to EM currencies, say $BRL or $ZAR. The idea is clear enough – USD strengthens when the US economy is either doing really well (risk-on, capital flows in) or really poorly (risk-off, flight to safety). My confusion arises when I try to overlay this with EM. If the US is booming, shouldn't capital flow out of EM into higher-yield US assets, weakening EM FX? And if the US is in a tailspin, capital also flees EM for safety, again weakening EM FX? It seems to imply EM currencies are always on the losing end of the dollar smile. Am I missing a nuance here, or is there a specific phase of the smile that's more favorable for EM FX than others, beyond just global growth benefiting commodity exporters?
It's a great question, and you're right, the EM FX component can make the 'dollar smile' feel a bit more nuanced. Typically, when the US is booming (risk-on), you'd see some capital flow back into higher-yielding EM assets, weakening the dollar against those. But the 'smile' also accounts for that flight to safety during US downturns, which is where EM currencies often take a hit.