Typically, a weaker US dollar helps developing countries by reducing their debt burden. However, the trade war that weakened the dollar also increased the risk premium on these nations, causing their actual borrowing costs to rise—an unusual and detrimental economic outcome.

A weakening dollar reduces the credit risk for dollar-borrowers, which encourages more dollar-denominated lending. This credit is the lifeblood of intricate global supply chains. As a result, exports of sophisticated goods, like semiconductors, can thrive even during periods of dollar weakness.

While tight credit spreads suggest low returns for investors, they serve a critical function: allowing lower-rated sovereigns to regain market access. This revival of issuance from countries like Ecuador and Pakistan, previously priced out, is a credit-enhancing event for the entire asset class, signaling an end to a recent wave of defaults.

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.

The U.S. dollar's decline is forecast to persist into H1 2026, driven by more than just policy shifts. As U.S. interest rate advantages narrow relative to the rest of the world, hedging costs for foreign investors decrease. This provides a greater incentive for investors to hedge their currency exposure, leading to increased dollar selling.

In a regime of fiscal dominance, where government spending dictates policy, the currency, not bond yields, becomes the primary release valve for economic pressure. While equities and yields may appear stable, the true cost of stimulus will be reflected in a devaluing dollar, a risk often overlooked by bond vigilantes.

The combination of restrictive trade policy, locked-in fiscal spending, and a Federal Reserve prioritizing growth over inflation control creates a durable trend toward a weaker U.S. dollar. This environment also suggests longer-term bond yields will remain elevated.

Contrary to a simple narrative of improved market sentiment, EM sovereign resilience stemmed from unexpectedly strong macro fundamentals. Better-than-forecast current account balances, export performance, FDI, and portfolio inflows were the primary drivers of stability, exceeding even conservative projections from two years prior.

Despite being at historically tight levels, EM sovereign credit spreads are unlikely to widen significantly from an EM-specific slowdown. The catalyst for a major sell-off would have to be a 'beta move' originating from a crisis in core US markets, such as equities or corporate credit, given the current strength of EM fundamentals.