(The opinions expressed here are those of the author, a

columnist for Reuters.)

By Jamie McGeever

ORLANDO, Florida, June 16 (Reuters) - A dramatic spike

in the potential for all-out war between Israel and Iran would

typically be expected to spark an immediate and strong rally in

the U.S. dollar, with investors seeking the safety and liquidity

of the world's reserve currency.

That didn't happen on Friday.

The dollar's response to Israel's strikes on Iranian nuclear

facilities and military commanders, followed by Tehran's initial

threats and retaliation, was pretty feeble. The dollar index, a

measure of the currency's value against a basket of major peers,

ended the day up only around 0.25%.

To be sure, the dollar fared better than U.S. stocks or

Treasuries, which both fell sharply on Friday. But with oil

surging over 7% and gold up a solid 1.5%, a strong 'flight to

quality' flow would have lifted the dollar more than a quarter

of one percent.

The U.S. currency's move was particularly weak given the

dollar's starting point on Friday. It was at a three-and-a-half

year low, having depreciated 10% year to date, with sentiment

and positioning heavily bearish. Yet a significant geopolitical

shock generated barely a knee-jerk bounce.

For comparison, the dollar rose more than 2% in both the

first week of the 2006 Israel-Lebanon War and in the week

following Israel's invasion of Southern Lebanon last year.

The dollar's weak response to this latest Middle East

conflict supports the narrative that investors are

now reassessing their high exposure to dollars, in light of some

of the unorthodox policies put forward by U.S. President Donald

Trump in recent months.

The dollar was down slightly early on Monday, and gold and

oil were giving back some of Friday's gains too, as markets

regained a foothold at the start of a busy week packed with key

central bank meetings.

PAINED SMILE

The dollar has historically been one of the best hedges

against short-term volatility sparked by geopolitical risk,

behind gold and on a par with oil, according to research

published last year by Joe Seydl, senior markets economist at JP

Morgan Private Bank.

Indeed, a Journal of Monetary Economics paper from last year

stated plainly, "The dollar is a safe-haven currency and

appreciates when global risk goes up," a trend resulting from

the "fundamental asymmetry in a global financial system centered

around the dollar" built up over the course of several decades.

That latter part of that argument hasn't changed.

The dollar accounts for almost 60% of the world's $12

trillion FX reserves, with its nearest rival, the euro,

accounting for around 20%. Almost two-thirds of global debt is

denominated in dollars, and nearly 90% of all FX transactions

around the world has the greenback on one side of the trade.

That means traders, financial institutions, businesses,

consumers and governments still need to be more exposed to

dollars than any other currency, even if they question the

direction of current U.S. policy.

However, the dollar's downside 'structural' risks are

growing, analysts at Westpac noted on Sunday, as concern over

Washington's fiscal health and policy uncertainty erode the

dollar's 'safe-haven identity'. Investors are now looking to

hedge their large dollar exposure more than ever.

If this dampens their instinctive demand for dollars in

periods of sudden geopolitical tension, uncertainty and

volatility, then the so-called 'dollar smile' theory could be

challenged.

This 'smile' is the idea that the dollar appreciates in

periods of financial market stress as well as in 'risk on'

periods of strong global growth and investor optimism, but sags

in between. This idea was first outlined over 20 years ago by

then currency analyst and now hedge fund manager Stephen Jen.

If the Israel-Iran conflict continues to escalate, that

dollar smile could get rather lopsided.

(The opinions expressed here are those of the author,

a columnist for Reuters)

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