Institutions say the fate of emerging markets depends on volatility rather than the US dollar

(1) The latest emerging market strategy report from an institution delivers a subtle message: the macro backdrop for emerging market forex and credit has become tougher, but this is a story of subdued returns rather than collapse. (2) The institution states that the trigger is its internally more hawkish view on the Federal Reserve; it now expects two further rate hikes, with risks tilted to even more hawkishness. It has also raised its forecasts for US Treasury yields and the US Dollar Index, now anticipating a US Dollar Index of 102 in Q4 2026 and 104 for the whole of 2027—higher than the previous estimate of 96 to 99. (3) The institution believes this constitutes a significant headwind for emerging market carry trades, already at historically low levels, while inflows into local currency bonds have far exceeded actual returns—by its measure, the largest gap since 2013. (4) The institution's interpretation is that inflows are likely to cool, rather than returns suddenly catching up, and points out that the South African rand and Mexican peso are its preferred tactical hedging tools. (5) Crucially, the institution notes that a stronger US dollar does not automatically kill emerging market carry trades. It identifies volatility rather than spot direction as the key swing factor. (6) Historically, a stronger dollar and lower volatility have dominated; in such environments, emerging market FX and local duration often post positive returns. The institution believes that resilient corporate earnings, rather than macro strength, are key in suppressing volatility. (7) On the credit side, the institution observes that emerging market sovereign spreads widened only moderately after absorbing about 90 basis points of US Treasury selloff, and its baseline scenario expects just another 10 basis points of widening by year-end. (8) The institution indicates that it has not sold, but will wait for a potential overshooting in spreads before turning bullish again, and is considering returning to overweight high yield at that time. (9) The institution also highlights a structural shift in emerging market drivers, noting that the influence of crude oil has risen significantly. Its three-factor model—crude oil, US Treasuries, and the US Dollar Index—now explains 55% to 60% of emerging market return variance, compared to about 25% before the Iran conflict, proving that emerging market macro drivers now go beyond the usual Federal Reserve and US dollar dynamics. (10) In summary, the institution states that higher yields and a firmer US dollar have raised the performance bar for emerging markets, but stronger fundamentals, controlled volatility, and resilient spreads mean returns are likely to slowly trend lower, rather than be repriced chaotically.