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.
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Unlike previous years dominated by a single theme, 2026 will require a more nuanced approach. Performance will be driven by a range of factors including country-specific fiscal dynamics, the end of rate-cutting cycles, election outcomes, and beneficiaries of AI capex. Investors must move from a single macro view to a multi-factor differentiation strategy.
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.
Emerging market monetary policy is diverging significantly. Markets now price in rate hikes for low-yielding countries like Colombia, Korea, and Czechia due to stalled disinflation. In contrast, high-yielding markets continue to offer attractive yield compression opportunities, representing the primary focus for investors in the space.
With dollar correlations at elevated levels, finding cheap, clean directional expressions against the dollar is challenging. Sophisticated traders are creating bearish dollar baskets that mix G10 currencies (AUD, NOK) with Emerging Market currencies (HUF, ZAR) to achieve greater pricing efficiency.
Despite investor nervousness after a strong 2025, EM currencies could appreciate against the dollar again in 2026. Analysts argue that the 14-year bear market has turned, citing historical precedent from the 2002-2010 bull market where consecutive positive years were common. This challenges the prevailing investor caution.
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.
The link between emerging market currencies (EMFX) and US tech stocks is not about the tech sector itself. Global equity markets have become a unified signal for the global economic cycle. A sell-off worries investors about global growth, impacting risk-on EM currencies regardless of their direct tech exposure.
Investor appetite for emerging markets is in an ideal state: not euphoric, but recovering. Recent inflows of $25 billion are just a fraction of the $159 billion that flowed out over the previous 3.5 years, suggesting the recovery is in its early stages with substantial potential for further investment.
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.
Despite high Euro risk reversals against the dollar, J.P. Morgan identifies a broad underperformance in Euro skew, particularly in LATAM crosses like EUR/BRL and EUR/MXN. This dislocation creates an attractive setup for volatility harvesting strategies, such as selling topside Euro calls through delta-hedged structures.