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.

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.

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.

Contrary to the belief that US strength harms the Euro, historical data shows the EUR/USD pair performs best when growth outlooks for *both* regions are being upgraded. This is because the Euro is fundamentally a pro-cyclical 'growth currency,' benefiting from a global risk-on environment even when the US also thrives.

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.

While a stronger growth environment supports EM currencies, it is problematic for low-yielding EM government bonds. Their valuations were based on aggressive local central bank easing cycles which now have less scope to continue, especially with a potentially shallower Fed cutting cycle, making them vulnerable to a correction.

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 Federal Reserve's dovish stance, combined with a resilient global growth outlook, creates a favorable environment for "pro-cyclical" currencies like the Australian Dollar and Norwegian Krone. This "middle of the dollar smile" scenario suggests betting on currencies sensitive to global economic momentum, not just betting against the dollar.