The Dollar Smile Theory: Why the US Dollar Strengthens in Good Times and Bad

Here’s a curious thing about the US dollar: it tends to rise when the world is falling apart… but also when the US economy is roaring. Odd combination, right? If things are bad, you’d expect the dollar to drop. And if everything’s great, maybe people would diversify into other currencies. Yet history keeps showing the opposite. Economists call this the Dollar Smile Theory. And once you walk through the idea, it actually feels pretty intuitive.

Why the Dollar “Smiles”

Picture a smile drawn on a graph (like the graph below). The left side is crisis. The right side is booming growth. The sagging middle is the “meh” zone, when things are neither terrible nor brilliant, just average. That’s when the dollar tends to drift.

In times of panic, investors want safety above all else. They buy dollars and Treasuries because those are still seen as the most dependable safe havens. Think 2008 or the early COVID panic in 2020: fear spiked, and the dollar did too.

On the other extreme, when the US economy is on fire, interest rates rise and returns look tempting. Money flows in, chasing growth and yield, and the dollar gets another lift.

But in the middle? When the economy is just okay, and other parts of the world look attractive, capital tends to flow elsewhere. That’s where the dollar loses its shine.

Source: Wellington Management

So it smiles: strong in bad times, strong in great times, weaker in the muddle in between.

A Few Real-World Moments

The theory isn’t just academic. In 2008, during the financial crisis, the dollar surged over 20% as investors piled into cash. Then in March 2020, during COVID’s market chaos, the same thing happened. The dollar spiked within weeks.

Now flip to 2022. The US economy was running hot, inflation was high, and the Fed was hiking aggressively. The dollar hit a twenty-year high against other currencies. By mid-2023, though, things cooled. Inflation eased, the Fed slowed, and the dollar dropped back. Classic smile shape: strong at the extremes, softer in the middle.

What Really Drives It

At the core it comes down to two things: interest rates and confidence.

• In boom times, high US rates make dollar assets more rewarding.
• In downturns, even if rates fall, the dollar is still the “safe” place to be.
• In between, neither force is strong enough, so the dollar weakens.

Think of it like personal behaviour. When you’re anxious, you hold cash. When you’re confident, you go big in the biggest market. Both support the dollar. When you’re just coasting, you might take your money somewhere else.

Why It Matters Outside of FX

The dollar’s smile doesn’t just affect currencies. When the left side of the smile kicks in, there’s global panic. Gold and the yen usually climb too, while stocks and risky debt slump. On the right side, there’s a US boom, where the dollar can rally alongside equities, while safe-havens like gold tend to lag.

Emerging markets feel the strain the most. A strong dollar makes their debt more expensive and often sparks capital outflows. When the dollar softens, they finally get some relief.

The Risks and Odd Exceptions

Of course, the smile is a framework, not a rule carved in stone. In 2023, when US regional banks wobbled, the dollar didn’t rally much because investors saw it as a local issue, not a global one. Longer term, big US deficits and rising debt could chip away at the dollar’s safe-haven role. And as other economies grow in weight, it’s fair to ask whether the dollar will always dominate to the same degree.

Takeaway

The Dollar Smile Theory isn’t about predicting precise levels. It’s about tendencies. The dollar shines when fear is high, and it shines when US growth is roaring. It struggles most in the middle ground. For investors, the trick is to know where we are on that curve. Are we bracing for a storm? Surfing a boom? Or just drifting along?

Spotting the smile early can help you position smarter, whether that means leaning on safe havens, backing US growth, or spreading risk when the dollar looks likely to fade. The dollar may not always smile, but when it does, it’s worth noticing.