By Mike Dolan

LONDON (Reuters) – Whether investors run for the hills or not after the past week’s stock market shakeout, the episode provides a glimpse of where to run for cover – and the U.S. dollar came up trumps.

In the past, dollar cash has been a refuge for those in financial stress. This was most evident when the global coronavirus pandemic hit in March last year.

Although fears of a China Evergrande-sized debt default sparked anxiety, it was not widespread enough to cause ripple effects among regional banks and high-yield markets.

The worries were enough to trigger the sharp pullback in global shares. The dollar was one of few winners of this storm.

Although that stock correction has been widely predicted – with a majority in a recent Deutsche Bank (DE:) client survey saying they expected a 5-10% correction by year’s end – the peak-to-trough plunge in MSCI’s all-country index this month almost reached 5% on Monday.

China’s property fears aren’t over and the financial volatility gauges remain at their highest levels in many months.

As a safe haven, the dollar’s main trading index has seen impressive gains. It was almost up 1% against gold, over 1.4% against sterling and almost 7% against the US.

The dollar’s independent performance is evident despite the fact that rival havens like Japan’s currency and Switzerland’s franc outperforming it over the past seven days.

It’s not just stress. Another big news event this week is the Federal Reserve’s recent policymaking meeting. This will provide alternative fuel to the currency.

Some currency experts see the dollar getting a unique double boost.

Paul Meggyesi, JPMorgan’s (NYSE:), and his team believe that the dollar can benefit from the so-called “dollar smile” at both ends of this phenomenon.

The’smile’ is a reference to the observation that both extreme stress or tension (when highly dollar-borrowed companies around the world scramble to obtain dollar cash and liquidity) and rapid global growth and risk taking (where U.S. Equity outperforms, and U.S. rate pushes higher) are good for the dollar. The weakest part of the dollar is found in between.

JPMorgan’s team said that “our confidence has increased” and the dollar was on the edge of a more clear break-out.

The smile is left-side showing growing anger at the fact that world growth has plateaued, policies are being pulled, global stocks have been oversold, and that there are “mounting international tail risks” from China.

The Fed and the “U.S. rates-driven exceptionalism” are on their right. This week, Fed policymakers are expected to announce the beginning of U.S. rate increases from late next year. They could also signal six additional hikes through end-2024.

REAL TIME

Interest-rate support for the dollar is sometimes overlooked by focusing on nominal U.S. bond yields in isolation – especially in a year like this one, when the dollar held firm even as U.S. Treasury yields recoiled during the summer.

The relative real or inflation-adjusted bond yields between the U.S., other countries, and regions is often a better indicator of the fortunes of the dollar.

After spending most of 2021 living in negative territory, such as Germany, the gap between two-year real yields and the U.S. has turned positive in the last month. This week, the premium for U.S. rates reached its highest point since June 2020. The U.S. rate premiums for ten-year equivalents are at their highest level since April.

If you see growth potential and inflation expectations as the main drivers of a currency’s fortunes this real rate view makes perfect sense.

If all things are equal, tighter monetary policies today mean lower inflation expectations and less currency value erosion over time. This assumes that growth potential is strong enough to support high rates and a higher “terminal rate” in tightening cycles.

This must be balanced against inflation and growth expectations in Japan or Europe.

Morgan Stanley (NYSE:)’s Matthew Hornbach and team also see the dollar lifted further by the rising real rate view. This week’s Fed meeting is expected to be a significant moment.

This week, they said that “The September FOMC might be a key catalyst driving U.S.(real) yields higher which we expect will boost the dollar broadly.”

(by Mike Dolan; Twitter (NYSE): @reutersMikeD. Editing: Kevin Liffey