IN FOCUS6-8 min read

The dollar smile theory: what is it and is it still valid in the new market regime?

Should the US enter recession before the rest of the world, the greenback would face a subdued period, according to the dollar smile theory. We discuss whether we think the theory still holds true.



Caroline Houdril
Portfolio Manager
Joven Lee
Multi-asset Strategist

“Good news” about the economy can be taken as “bad news” for financial markets in an environment like the one in 2022, where inflation was firmly in charge and monetary policy normalisation was underway.

In such a setting, both equities and bonds can lose money at the same time, meaning there are fewer places for investors to hide. The US dollar can then play a unique role, as it did last year; benefitting from rising interest rates and worries about the path of growth.

Looking ahead into 2023, it might be growth – not inflation – that keeps investors up at night.

Given this shift in investor focus, we felt it was worth putting last year’s standout winner in the spotlight and revisiting the role of the US dollar in portfolios.

What is the dollar smile?

First, we should highlight that what happened with the US dollar last year reflects a phenomenon known as the “dollar smile”.

The dollar smile was observed 20 years ago by Stephen Li Jen and refers to when the US dollar outperforms other currencies in two extremely different scenarios:

  1. When the US economy is strong and there is optimism in markets
  2. When the global economy is doing badly and risk appetites are low (a ‘risk-off’ environment)
dollar smile

The theory is that when the US economy is strong and enjoys strong GDP growth, investors will invest heavily in US assets, thereby further driving up the value of the US dollar. Conversely, in risk-off environments, investors will flock to perceived safe-haven assets like the US dollar and the sheer demand will again drive up its value.

In the middle of the two extreme situations, the US dollar will flounder if US equity markets struggle to perform well relative to other global markets, as flows from the US dollar will be redirected into riskier but better-performing assets. This is where we are today.

How much does a dollar cost?

Looking ahead, we are potentially in a rare situation where the US may enter a recession ahead of other countries. Historically, a recession in the US is always followed by a recession in the rest of the world. In global recessions, how does the US typically dollar perform? Here, we calculate the returns using the US dollar index (DXY Index) during global recessionary periods as determined by our Global Wave model.

The Global Wave is made up of seven equally-weighted components, standardized to a z-score. The seven components are: industrial confidence, consumer confidence, capacity utilisation, unemployment, producer prices, credit spreads and earnings revision ratio. The Global Wave model covers over 30 countries which are GDP-weighted, and the final Global Wave indicator is then converted into an index that oscillates around a threshold of 50.

dollar smile

How about periods where the US in recession, but other economies have yet to catch up? Here, we analyse the average returns of the dollar index when the US is in recession but the rest of world is not, and when both the US and the rest of the world is in recession.

dollar smile

Here we can identify two things:

  1. When US is in recession before global peers, investors will choose to invest in better-performing assets, and the US dollar will struggle.
  2. When both the US and global peers are in recession, the US dollar experiences a reversal of fortunes. One explanation is that during a global risk-off environment, investors will flock to the US dollar as a perceived safe-haven asset, and the demand drives up the value of the dollar.

What role did the US dollar play in portfolios, and how can we think of it going forward?

In 2022, both equity and bond markets sold off. In a straightforward 60/40 portfolio, there was little to no diversification benefits from owning bonds, because of monetary policy normalisation through central bank rate hikes.

In the entire investment universe, only a small handful of asset classes provided positive returns over the year, and the US dollar was one of them. Investors used the US dollar as the ultimate safe haven. In currency baskets, the US dollar practically trumped all others and investors were hard-pressed to find any alternatives. Our hedge monitor, which allows investors to consider the efficiency of a hedge against the cost of holding it, supports this picture. The US dollar currency pairs (where an investor goes long on USD and short on another currency) currently fares better on the hedge monitor than assets that were traditionally viewed as a hedge, such as government bonds and gold.

dollar smile

We think that the dollar smile theory remains valid in this new regime. As our economists are forecasting the US economy to enter a recession before the rest of the world later in the year, the US dollar may be subdued until a time comes when global economies follow suit. In situations where a US recession precedes the rest of the world, we believe other drivers such as rates trajectory, the safe-haven status and - more importantly - liquidity are better indicators to focus on.

When the rest of world finally follows the US into a recession, what returns might we expect from the US dollar? We analysed the average returns of the US dollar index in a global recession and found that the most consistent strengthening of the dollar was achieved during scenarios when the US economy outperformed others - the US outperformed rest of the world more frequently.

dollar smile


Everything is relative. The growth prospects of the US relative to the rest of world is crucial to the US dollar’s outperformance. Right now, our economic models point to a global slowdown, with the US market expected to underperform peers. As a result, we believe we should focus on drivers such as monetary policy and liquidity conditions when analysing the potential benefits of investing in the US dollar.


Caroline Houdril
Portfolio Manager
Joven Lee
Multi-asset Strategist


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