Morgan Stanley: Economic Re-Coupling Will Boost the Dollar Smile in 2008

The dollar’s general weakness so far in 2008 gives little support to the 'Dollar Smile' theory. But according to Stephen Jen, Luca Bindelli and Charles St-Arnaud in the Global Economic Forum, Morgan Stanley believes that the Dollar Smile will eventually work, admittedly with a delay.

As opinions among investors change - particularly those on the U.S.'s slowdown being felt primarily in the U.S., and also the low yield premium on USD assets - Morgan Stanley foresees the following effects on the dollar:

"... [a] rally this year against the EUR and the GBP. In turn, the JPY and CHF could rally against the strengthening dollar, for as long as the U.S. is in a recession, which we believe will likely persist through 1H08. One by one, various parts of the rest of the world will start to show signs of a slowdown/deceleration. Even though we are of the view that this ‘economic re-coupling’ will be tentative and partial, financial coupling will likely push investors back into ‘fear mode’ and bond rather than equity flows will, perversely, support the dollar – consistent with our ‘Dollar Smile’ framework.

On decoupling:

"... while in the past, when the U.S. caught a cold, the rest of the world got pneumonia, these days, if the U.S. economy catches pneumonia, the rest of the world's economy will catch a cold. At the same time, however, financial coupling is likely to have remained quite high, we have warned, and an outright bear market in the U.S. would likely lead to a bear equity market elsewhere – which is precisely what our equity strategists believe will be the case in 2008, at least in 1H.

... While we are of the view that the degree of economic coupling has declined substantially in recent years, financial coupling is likely to have remained high – high enough to preserve the left side of the ‘Dollar Smile’.