The EM FX risk appetite index, which has a strong track record of predicting downturns, is at an extreme level, suggesting a correction. However, the model was trained during a dollar-bullish cycle and may be misinterpreting the current pro-cyclical, bearish-dollar environment, potentially making its contrarian signal less reliable this time.
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Analysts expect a continued dollar-centric market where most G10 currencies move in tandem against the dollar, keeping dollar correlations high. However, they are bearish on cross-correlations (e.g., involving Sterling and Euro), anticipating greater divergence between non-dollar currencies, which presents an opportunity for investors.
The positive outlook for EM assets is now a consensus view, dangerously reliant on two core assumptions: a strong global cyclical backdrop and the outperformance of metals over energy. This widespread agreement creates a "lack of imagination" for potential downsides, making the market vulnerable if these pillars falter.
Unlike emerging markets where pro-cyclical trades are crowded, positioning data shows the bearish US dollar view is not widely held in G10 currencies. This lack of a broad consensus short means there is less risk of a sharp deleveraging, giving pro-cyclical G10 FX more room to appreciate against the dollar.
A paradox exists in emerging market FX positioning. Medium-term structural indicators show that the asset class is not over-owned, suggesting room for growth. However, short-term technical indicators are approaching an "extreme positive threshold," signaling a high risk of a near-term pullback, particularly in currencies highly sensitive to the global cyclical backdrop. This warrants a more selective investment approach.
A J.P. Morgan risk appetite index, which has reliably signaled EM currency reversals, is currently not working as expected. This failure may stem from its training data, which comes from a long-term bullish dollar era. A potential shift in this macro regime could be rendering the technical indicator obsolete.
J.P. Morgan's 2026 outlook is "Bearish Dollar, Bullish Beta," favoring pro-cyclical and high-yield currencies. They expect the dollar's decline to be smaller and narrower than in 2025 unless US economic data significantly weakens, shifting from the more aggressive bearishness of the previous year.
The initiation of the Fed's cutting cycle is the critical trigger for a weaker dollar against EM currencies, outweighing any mixed forward-looking commentary. This is because the cycle's start begins to erode the US carry advantage, a key structural factor supporting EM FX performance.
While the macro environment appears supportive of pro-cyclical currencies, several warning signs could trigger a correction. Notably, the aggressive flattening of the US yield curve (e.g., 5s30s spread breaking below 100bps), even if driven by stronger growth, historically signals caution for high-beta assets and could challenge the current consensus view.
Emerging vs. developed market outperformance typically runs in 7-10 year cycles. The current 14-year cycle of EM underperformance is historically long, suggesting markets are approaching a key inflection point driven by a weakening dollar, cheaper currencies, and accelerating earnings growth off a low base.
Stronger US growth isn't hurting EM currencies because growth is also being revised up globally in places like China and Europe. This prevents a repeat of the 'US exceptionalism' theme that typically strengthens the dollar and pressures EM assets, making the current environment less problematic for EMFX.