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.

A key risk to the bullish outlook for Emerging Market currencies is the return of 'US exceptionalism,' where US growth significantly outpaces the rest of the world. As long as EM growth remains robust and comparable to the US, EM central banks can be proactively hawkish, supporting their currencies, rather than defensively weak.

The momentum of carry trades in high-yield emerging market currencies is remarkably persistent. Historical experience shows that currency appreciation driven by carry can continue for up to six months after the local central bank initiates an easing cycle, suggesting traders should not exit the position at the first sign of a policy pivot.

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.

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.

A synchronized global cyclical uptick, rather than standout US performance, is expected in the second half of the year. This dynamic is favorable for emerging markets as it reduces upward pressure on the US dollar, preventing significant interest rate divergence and supporting EM currencies.

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.

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.