The Disappearing Dollar Smile

Key Capital Private, Investment Note - Issue #30

The Disappearing Dollar Smile

Gold prices are rising in a straight line, bitcoin is rising in a straight line, U.S. Treasury yields are near recent highs, and yet the U.S. dollar is falling in a straight line - something appears off.

• One of the most striking developments in 2025 has been the sustained weakness of the U.S. dollar, which has declined by almost 10% against major trading partners, despite an environment that would typically support it.

• This has challenged the traditional "Dollar Smile" framework, a theory that the dollar tends to strengthen at both ends of the economic spectrum: during periods of robust U.S. growth and global crises, while weakening during stable, low-volatility periods in between. Historically, this pattern has generally held. The dollar surged in the late-1990s tech boom, during the 2008 financial crisis, and again in the wake of COVID-19, forming a distinct U-shaped pattern that gave the "smile" its name. Conversely, during the mid-2000s (2004–07), a period marked by global stability and low volatility, the dollar steadily weakened.

• But 2025 has produced catalysts that traditionally support the U.S. currency - high Treasury yields, sticky inflation, geopolitical tensions – and yet it is selling off. Investors are rotating into gold, Swiss francs, and bitcoin, not because the world is stable, but perhaps because they’re questioning the credibility of U.S. fiscal management and no longer treating U.S. assets as untouchable.

Reserve Status

• The U.S. faces three conflicting goals: (1) a desire for a weaker/more competitive dollar to support manufacturing, (2) maintaining the dollar's reserve currency status, and (3) attracting sustained capital inflows to fund large fiscal deficits.

• The U.S. has long benefited from the “exorbitant privilege” of having the dollar serve as the global reserve currency, enabling it to borrow externally in its own currency and run persistent trade and fiscal deficits with limited repercussions. While most developed market countries also issue debt in their own currencies, the unique global demand for dollar assets has allowed the U.S. to do so without any concern about demand.

• But the downside of persistent trade deficits is a growing reliance on foreign ownership of U.S. assets, and this reliance may be reaching its limits. Following Liberation Day, the sell-off in U.S. equities, bonds, and the dollar sparked fears of a broader shift away from American financial dominance. While equity markets have since rebounded - with the S&P 500 now up ~30% in dollar terms from its 2025 low - the dollar’s recovery has been more muted, with the DXY (the dollar value relative to a basket of foreign currencies) only ~1% higher from its low, reflecting lingering scepticism toward U.S. assets (Source: Bloomberg as of 14.08.25).

• If the dollar continues to fall, investors may worry that a structural shift is underway, which could erode its reserve currency status. But history tells us this process is slow and nonlinear. Sterling, for example, began losing its reserve currency status in the 1920s, but GBP/USD stayed relatively stable until after World War II. The real decline came in the post-war era. Likewise, the U.S. dollar has weathered structural bear markets before - declines in the 1970s, late 1980s, and 2000s - while still serving as the World’s primary reserve asset. The more pertinent question is not if the dollar loses its crown, but whether demand for U.S. assets is eroding under the surface and if we are on the cusp of another structural dollar bear market.

Soiling its Shirt

• Since the financial crisis, the strength of the U.S. dollar has owed much to relatively stronger economic growth and higher interest rates compared to other developed economies. Despite persistent trade and fiscal deficits, the dollar was seen as the “cleanest dirty shirt”, not pristine but still more attractive than alternatives like the euro, yen, or emerging market currencies, which faced their own structural challenges.

• But now U.S. 10-year yields persist at elevated levels at a time when the ECB is cutting rates, and the Fed remains on hold. Under normal conditions, this divergence should support the dollar by attracting yield-seeking capital. Instead, the dollar has declined rapidly, albeit from a strong starting point.

• The U.S. is on track to issue c. $2 trillion in new debt this year (Source: U.S. Department of the Treasury), adding to a pattern of trillion-dollar deficits. But what’s changed since the 2010s is the buyer base. The Fed is now running quantitative tightening, and foreign central banks have become net sellers this year (Source: New York Fed). The traditional "price-insensitive" demand for U.S. debt is being tested, and this has left domestic investors - mutual funds, banks, households - to fill the gap. But they’re demanding a higher premium for absorbing the increased fiscal risk. Notably, Treasury yields have remained high even after risk assets stabilised post Liberation Day. This might suggest that the market’s concerns are no longer just event driven.

• This matters for the dollar with U.S. Treasuries acting as the anchor to the dollar’s reserve currency status. If bonds lose their perception as "safe haven assets," the dollar can no longer rely on crisis demand to uphold its value, breaking one of the two key pillars of the Dollar Smile. The other, strong growth is being undermined by fiscal instability.

Short-Term Gain, Long-Term Pain

• In response to higher long-term yields, the U.S. Treasury has increasingly relied on short-term debt to fund its deficits. In Q3 2025 alone, over $1 trillion in new issuance is planned via Treasury bills maturing in weeks or months, the highest short-dated share of issuance in years (Source: Barron’s). This may reduce immediate borrowing costs, but it raises interest rate risk. Short-term debt must be rolled over frequently, making public finances more sensitive to rising rates. Had more long-term debt been locked in during the low-rate 2010s, today’s interest burden would be far lower.

• Some economists call this strategy a form of "stealth QE", suppressing long-end yields without central bank intervention. Investors are demanding better compensation for absorbing fiscal and rollover risk.

Conclusion

History shows that reserve currency status changes slowly, but this year has highlighted vulnerabilities in the dollar’s position. The debate today seems less about “de-dollarisation” and more about whether foreign and domestic investors still want to hold U.S. assets at scale. Will 2025 be remembered as the year the dollar’s dominance began to crack?