While still profitable, FX carry trades have become more cyclical and less of a diversifier. They now exhibit a high correlation (~0.5 beta) with the S&P 500 and offer significantly lower yields (7% vs. 11-12% previously), increasing their risk profile in a potential market downturn.

Traditional analysis links real GDP growth to corporate profits. However, in an inflationary period, strong nominal growth can flow directly to revenues and boost profits even if real output contracts, especially if wage growth lags. This makes nominal figures a better indicator for equity markets.

Despite a major geopolitical shock, Emerging Market currencies have held up remarkably well. In contrast, EM rates markets have shown significant stress, indicating painful positioning squeezes and a reassessment of inflation risks by investors. This divergence signals underlying strength in some areas but reveals hidden fragilities in others.

The success of the current EM FX carry trade isn't driven by wide interest rate differentials, which are not historically high. Instead, the strategy is performing well because a resilient global growth environment is suppressing currency volatility, making it profitable to hold high-yielding currencies against low-yielders.

For FX carry strategies, inflation is a more critical driver than growth. This is because inflation forces divergent central bank responses, creating the yield dispersion that carry trades exploit. Growth only becomes the dominant factor during a recessionary shock, when carry strategies typically collapse.

Despite record-high economic activity surprises, emerging market currencies (EMFX) are fairly valued, not overextended. This suggests near-term upside for spot prices is limited, making carry returns the more likely driver of performance in this bullish cyclical environment.

While broad emerging market currency indices appear to have stalled, this view is misleading. A deeper look reveals that the "carry theme"—investing in high-yielding currencies funded by low-yielding ones—has fully recovered and continues to perform very strongly, highlighting significant underlying dispersion and opportunity.

The most effective FX expression of the AI theme is through carry strategies, not by picking individual currencies. FX carry shows a high correlation with AI-beneficiary equity sectors like tech and energy. This allows a broad basket of high-yield currencies to outperform as a group, even those without direct AI exposure.

When asset valuations are elevated across all major markets, traditional fundamental analysis becomes less predictive of short-term price movements. Investors should instead focus on macro drivers of liquidity, such as foreign exchange rates, cross-border flows, and interest rates.