The yen smile: New economic era

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What is the US Dollar Smile Theory?

More than 20 years ago, former International Monetary Fund economist Stephen Li Jen introduced the US Dollar Smile Theory, which explains how the US dollar tends to strengthen in two opposing economic scenarios — when the US economy is very strong or very weak.

This theory argues that the dollar appreciates during periods of economic strength due to increased investment in US assets, and during times of economic stress given its reserve currency status. When the economy is neither too hot nor too cold, the dollar can depreciate modestly in value versus other currencies. Jen observed that this behavior forms a smile shape when plotting its strength under different economic conditions. This concept is illustrated in Figure 1.

Figure 1

Is the US dollar losing its reserve currency status?

The macroeconomic landscape has changed significantly since Jen first identified the US Dollar Smile Theory. Trends toward deglobalization have been simmering for some time now, and US President Trump’s tariff plan pours gasoline on that fire. With a new regime for global trade, currency behavior is likely to change. With the US administration seeking to reduce its trading deficit with its trading partners, there may be less foreign capital flowing into the US. The result could be that the US dollar smile morphs into a frown as global investors question how best to allocate their investment capital.

Strong asset market performance and a long-standing trend of US exceptionalism have driven flows into US assets over many years. This has helped keep the US dollar smiling, but it may not be able to continue in the face of:

A less clear path for US exceptionalism
Supportive fiscal backdrops outside of the US, notably in Japan, Germany, Canada, and Australia
Competitive investment alternatives outside of the US, such as AAA-rated sovereign debt in Australia and New Zealand, which provide relatively higher yields

Combining this with an assessment that the US dollar remains anywhere from 10% – 20% above its long-term real-trade-weighted basis, there is good reason to expect investment flows into the US to slow and/or be diverted elsewhere. If this is the case, the US dollar may depreciate over the coming months and quarters.

Could the Japanese yen be a new “safe-haven” currency?

With the US dollar potentially losing its shine, an alternative, the Japanese yen, could start to beam. The yen has long been considered a relative “safe-haven” currency that has benefited from the left-hand side of the “smile” due to:

Japan holding a very large net international investment position, estimated to be more than 80% of GDP, which can be repatriated back home in times of financial and/or economic stress
Japan being a low-yielding market that benefits from carry trade unwinds in times of deleveraging

For the past two to three years, the Japanese yen has somewhat lost its safe-haven status because the Bank of Japan (BOJ) monetary policy was extraordinarily loose compared to other central banks, which increased interest rates in response to rising global inflationary pressures. In a sense, the interest-rate gap that opened up between Japan and the rest of the world became so wide that it negated the yen’s safe-haven properties, and the US dollar, which has offered one of the highest interest rates available, smiled more than ever.

Today, the interest-rate gap between Japan and the rest of the world has started to close. The yen is regaining its safe-haven status, as evidenced by its recent performance over ”Liberation Day” in the US. At the same time, it’s possible the Japanese yen may start to exhibit behavior more commonly associated with the right-hand side of the smile. This is because the BOJ is the only major central bank that continues to increase interest rates. Most other major central banks believe — correctly or incorrectly — they’re on a path to lower policy rates.

With a cloud of trade policy-induced uncertainty now expected to keep the BOJ on hold for the rest of 2025, any sign of this lifting will likely open the door for further BOJ interest-rate hikes, which would continue to narrow the interest-rate gap between Japan and other major markets, leading to a stronger yen. Therefore, a stronger economic outlook could now be associated with a strong yen and the currency could regain its more traditional safe-haven properties.

Figure 2

What’s more, despite some recent, modest appreciation, the yen remains close to its weakest level in more than 50 years on a real effective exchange-rate basis (Figure 2). So, the smile could be just beginning.