The weakening dollar is beginning to transform emerging markets. But not in the simple way investors usually imagine. For traditional investors, the combination looks almost ideal. US policy is becoming less supportive of the dollar, Washington is increasingly uncomfortable with high long-term Treasury yields, and emerging-market central banks continue to offer extraordinarily high real rates. The result has been one of the strongest carry environments since the global financial crisis. Dollar-funded EM carry trades have now delivered positive returns for seven consecutive quarters, the longest run since 2008. A Bloomberg basket of eight major emerging-market currencies has returned around 22% since the end of 2024, comfortably ahead of Treasuries and dollar-denominated EM debt. Over the past year alone, carry returns reached roughly 48% in the Colombian peso, 21% in the Brazilian real and 19% in the Mexican peso.

The mechanism is powerful. Borrow in a relatively low-yielding currency. Invest in a country offering double-digit rates. Collect the differential. And, crucially, avoid losing it through currency depreciation. The last element has changed. The dollar is weakening while many EM currencies are appreciating or remaining stable. High nominal yields are therefore increasingly becoming real investment returns rather than compensation for future FX losses. This explains why capital is returning. But there is a paradox.

The same interest-rate differential that makes emerging-market carry attractive to an unhedged investor makes those currencies expensive to hedge back into dollars. That distinction is becoming increasingly important. Take a market where local rates are 10%, and US rates are 4%. The investor willing to hold the currency can capture much of that six-point differential. An investor who must hedge FX exposure back into dollars largely gives it away in the forward market. If US rates now fall while the local central bank remains at 10%, the carry trade becomes even more attractive. The hedge becomes even more expensive. The weak-dollar regime therefore creates winners and losers inside the same asset class. For global macro investors, it is an opportunity. For institutions that cannot retain emerging-market currency risk, it can become a deployment constraint.

This is particularly relevant because the current dollar weakness may be more structural than cyclical. Scott Bessent’s attempts to contain long-term Treasury yields have reinforced what markets increasingly describe as the debasement trade: weaker dollar, stronger gold and greater demand for assets outside conventional US duration. Washington can alter the maturity profile of Treasury issuance and influence liquidity, but it cannot eliminate the fiscal deficit, inflation risk or the enormous competition for global capital. If the Treasury succeeds in preventing some of that adjustment from occurring through higher yields, part of it can migrate into the currency. That is positive for EM spot performance. It is not necessarily positive for hedging costs.

There should eventually be a second phase. A persistently weaker dollar reduces imported inflation across many developing economies. Oil, commodities and manufactured imports become cheaper in local-currency terms. Currency stability also reduces the need for central banks to maintain punitive interest rates simply to defend exchange rates. That eventually creates room for cuts. And once EM rates begin falling faster than US rates, the differential narrows. Hedging costs decline. The problem is timing. Middle Eastern tensions and elevated energy prices are delaying that process. Central banks in Latin America and Eastern Europe remain reluctant to ease aggressively while inflation risks persist. The carry opportunity can therefore remain exceptionally attractive for investors while hedging costs stay painfully high for borrowers and institutions that need currency protection. This could last several months.

There is another risk. Carry trades become most dangerous when everybody understands them. High yields, a weakening funding currency and relatively low FX volatility attract capital rapidly. That pushes currencies higher, compresses local yields and reinforces the conviction that the trade is safe. Until something changes. The obvious threat would be a renewed repricing of US rates. If inflation forces the Fed back towards tightening, the dollar could rebound sharply and crowded EM positions would unwind. For now, however, the opposite regime remains dominant. The dollar is weakening. EM currencies are holding. Real yields remain high. Capital is moving towards carry. This is exceptionally supportive for unhedged emerging-market investors.