Capital Rules Everything Around Me: USD Debt, Assets & The Dollar Smile Theory
Capital Rules Everything Around Me
Part Two: USD Debt, Assets & The Dollar Smile Theory
In an earlier piece, I argued that it is capital: specifically the emergence of a liquid capital market that offshore participants can easily participate in, that has tended to drive the development and sustained dominance of a reserve currency. In this case, it is the U.S. dollar (USD).
The reality, though, is that capital is fickle and cross-border flows can greatly impact the value of a currency. In fact, portfolio flows’ volume is significantly more than trade-related flows. As a result, the existence of an offshore funding market can greatly influence short-term fluctuations in the value of the USD.
This piece will explore this dynamic further, digging into Stephen Jen’s ‘Dollar Smile Theory’ and outlining how both the global capital cycle and investor sentiment have tended to drive price action in the value of the USD, which multinational corporates and investors then have had to contend with.
Cross Border Capital Markets – Big Daddy Dollar
The reality is the USD dominates as an offshore funding and investment currency, and the market is enormous.
In fact, while the United States only accounts for 25% of global GDP, close to 50% of all cross-border bank and bond debt is denominated in US dollars. It is the existence of this dollar-dominated debt that has tended to influence the currency flows driving short term USD pricing.
The value of this stock of debt? The amount of outstanding international debt securities and cross-border loans that are U.S. dollar funded was $22.6 trillion as of Q4 2019.
Adding to this dynamic is the fact that a significant proportion of the entities issuing and trading in USD-denominated debt/assets are non-U.S. entities. As such they don’t have stable access to USD funding the same way U.S. banks do via the Federal Reserve or retail bank deposits.
The Dollar Smile and Global Capital Cycles
The role that U.S. treasuries have tended to play in recent history as the global ‘safe haven’ asset is widely known, which explains the traditional negative correlation between risky assets like U.S. equities and the USD.
What is less well known is the impact USD-denominated liabilities, originated and owed offshore, has tended to have in driving the ‘spikiness’ in the USD that is often seen in times of market distress. This also has tended to have significant implications for dollar liquidity outside of the United States (more on that later).
Stephen Jen’s “Dollar Smile” theory posits that the dollar tends to strengthen in two scenarios:
When the U.S. economy is booming: Attracting capital due to higher yields and stronger growth relative to the rest of the world.
When there is global distress: Driving investors to flee to safety in USD assets—especially Treasuries.
The Middle of the Smile – Where Imbalances Grow
The dollar tends to weaken in the middle of the smile: during periods of moderate global growth and risk appetite when investors are comfortable moving capital abroad. It is these periods of weakness in the US dollar that often coincide with the growth of dollar-denominated debt issued offshore.
At that point in the “smile,” U.S. interest rates have typically not yet increased materially from the lows achieved when the Federal Reserve cut rates to boost growth, and sentiment tends to improve while market volatility subsides.
Source: Bank for International Settlements: Statistical release: BIS international banking statistics and global liquidity indicators at end-December 2024; published 30 April 2025
The Hidden Risks: Global Dollar Shortages
Here’s the paradox inherent in the offshore dollar system: The world needs dollars. The U.S. benefits from this reliance, but the rest of the world doesn’t control the USD.
In periods of tightening U.S. monetary policy, dollar interest rates, and thus the cost of dollars rise. Emerging markets that owe debt in dollars then face higher repayment costs and reduced access to new financing. This has, at times, led to a persistent dynamic of dollar shortages, whether in times of fear or euphoria. So what?
The reality is the USD is a very volatile currency, in the sense of its currency market exchange value relative to other fiat currencies. U.S. corporates and consumers are often insulated from this because their exposure to this volatility is indirect.
That said, understanding the dynamics of the USD, specifically through the lens of the Dollar Smile Theory as a useful (though certainly not infallible) mental shortcut, can be helpful for businesses and investors operating globally, and especially those exposed to emerging market currencies.
More than trade, capital flows have tended to drive short-term currency movements, and the size and scale of capital markets dwarfs the “real economy” of import/export of tangible goods, meaning volatility and spikes and troughs in the U.S. dollar can hit hard and fast. Ignoring this reality risks mispricing exposure, misjudging risk, and potentially missing crucial signals in market cycles.
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DISCLAIMER: Opinions expressed in this article are those of the author. This article is for informational purposes only and does not constitute advice. Hedging products involve trade-offs, risks, and costs, and results may vary. Before making any decisions, consult an independent advisor not affiliated with Corpay to ensure that the solutions discussed are suitable for your business needs. A comprehensive under-standing of the complexities, benefits, and drawbacks of each hedging product is essential.
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