Emerging-Market Carry Trades Had a Standout 2025. Can the Rally Survive 2026?

Borrowing in a low-yielding currency and investing in a higher-yielding one is the basic logic of a currency carry trade. In the emerging-market version, investors typically take exposure to currencies or local-currency bonds with high interest rates while funding the position in dollars or another relatively cheap currency.49

That strategy delivered an unusually strong run through 2025 and remained resilient into 2026. A Bloomberg measure gained roughly 17% in 2025—the best performance since 2009—while another report described dollar-funded EM carry as having its longest winning streak since 2008.46 The important qualification is that carry returns are not guaranteed interest income: a fall in the target currency can erase months of yield in a short period.

Why dollar-funded EM carry worked so well

Wide yield differentials created a large income cushion

The trade benefited from substantial gaps between funding costs and EM interest rates. In some markets, the gap remained attractive even after adjusting for inflation. Reuters reported real one-year yields above 5% in the Dominican Republic, Ghana and Zambia, and above 10% in Egypt, Uganda and Ukraine, although high inflation also shows why headline yields can be misleading.1

Turkey became a prominent example of the high-carry opportunity. Analysts continued to point to the lira because tight monetary policy and high interest rates offered a substantial carry cushion, while also warning about crowding and country-specific risks.78

The key calculation is total return, not the policy rate alone:

Carry return ≈ interest-rate advantage + currency movement + bond-price movement − funding and transaction costs.

A currency depreciation larger than the interest-rate advantage turns an apparently attractive position into a loss. Real yields, inflation expectations, liquidity and the credibility of monetary policy therefore matter as much as the advertised nominal rate.123

A weaker dollar helped both sides of the trade

During much of 2025, dollar weakness made the US currency an especially convenient funding currency. Investors could borrow dollars relatively cheaply, buy higher-yielding EM assets and face less pressure from appreciation in the funding currency. Reuters reported a resurgence of dollar-funded positions in currencies including the Indonesian rupiah, Indian rupee, Brazilian real and Turkish lira.3

The effect was reinforced by capital flows. Research cited by J. Safra Sarasin found that dollar depreciation and lower US policy rates were important drivers of flows into emerging-market assets, with the dollar’s movement particularly relevant for local-currency bonds.38

Low volatility made the yield look more attractive

Carry is most appealing when the target currency is stable. In that environment, investors can collect the interest differential without immediately suffering a large FX loss. Bloomberg and ING both described declining volatility as a central reason the strategy performed well, while ING highlighted the importance of carry relative to volatility in assessing opportunities.410

This is also why the trade can appear safer shortly before it becomes dangerous. Low volatility encourages leverage and larger positions. If volatility then jumps, the cost of holding the position rises at the same time that risk limits, stop-losses and margin requirements begin forcing investors to sell.

Resilient growth supported EM assets

The broader backdrop was favorable for emerging-market debt and currencies. Investment managers cited economic resilience, lower volatility, carry and supportive technical conditions as reasons to remain constructive on EM debt, while emphasizing that fiscal and political risks vary significantly by country.3640

This was not a uniform rally across every emerging market. The strongest opportunities were concentrated in countries where high yields were accompanied by some combination of credible monetary policy, improving inflation, external buffers or strong market liquidity.

What changed in 2026?

The 2026 story is less straightforward than the 2025 rally. Early reports showed continued momentum: one Bloomberg-linked measure was reported up about 1.3% year to date by late January.6 But as the dollar regained strength, traders increasingly shifted from dollar funding toward currencies such as the euro and Australian dollar when financing EM positions.2

That shift matters because it shows that the trade is not simply a broad bet against the dollar. It is a relative-value strategy whose returns depend on the funding currency, the target currency, interest-rate expectations and volatility. A position can remain attractive even when the dollar is strong—but the best funding currency may change.

The outlook for the rest of 2026

The base case from institutional EM-debt commentary is cautiously constructive rather than indiscriminately bullish. Carry can continue to work if inflation remains contained, global growth avoids a sharp downturn and currency volatility stays manageable.3640

The more durable version of the trade is likely to be selective. Investors have reasons to favor markets with:

• positive real yields rather than high nominal yields alone;
• credible and sufficiently restrictive monetary policy;
• manageable fiscal and political risks;
• adequate external financing or current-account support; and
• liquid currencies and bond markets.

Expected EM policy-rate reductions are an important constraint. A median decline of roughly 50 basis points was estimated for 2026 in one outlook, suggesting that some of the yield advantage could gradually narrow.35 As rates fall, currency stability becomes more important: the trade has less interest income available to absorb depreciation.

Franklin Templeton likewise argued that 2026 EM performance should be driven more by carry than by a broad-based compression in risk spreads, while noting that selective FX outperformance does not require a universal collapse in the dollar.37

What could reverse the rally?

A Federal Reserve or dollar shock

A more hawkish Federal Reserve, sticky US inflation or higher Treasury yields could raise the relative cost of dollar funding and reduce the appeal of EM assets. A rapid dollar surge would be especially damaging because it could produce both a higher funding burden and losses on the target currency.

The opposite risk also exists inside emerging markets: faster-than-expected EM rate cuts would narrow yield differentials and remove part of the carry cushion.3536

A volatility spike and forced deleveraging

The August 2024 yen-carry unwind illustrates the trade’s mechanical vulnerability. Changing expectations for interest rates and a sharp increase in volatility put leveraged positions under pressure. The BIS concluded that higher margins and deleveraging amplified the move, forcing strategies built on contained volatility to unwind.4647

The same sequence can affect a dollar-funded EM position even when the original funding currency is not the yen:

1. Rate expectations or risk appetite change.
2. The funding currency strengthens or the target currency falls.
3. FX volatility rises and leverage becomes more expensive.
4. Stop-losses, margin calls and risk limits force investors to sell.
5. Selling pushes EM currencies and bonds lower, worsening the original losses.

Yen strength and shared portfolio leverage

The 2024 episode also shows why yen policy can matter beyond yen-funded trades. The yen is a major funding currency, and a sharp appreciation can lead investors to reduce leveraged positions across markets. Reuters described the 2024 unwind as a reaction to Japanese rate increases, a volatile yen and changing expectations for US policy.43

That does not mean every dollar-funded EM trade will unwind in the same way. It does mean that funding currencies, collateral and portfolio risk limits can connect positions that look separate on paper.

Geopolitical, oil and food-price shocks

A broader Middle East escalation or a sustained energy shock could raise inflation, weaken growth and damage current accounts in oil-importing emerging markets. Investment research has identified geopolitics, commodity volatility, recession risk and a potential technology-cycle correction among the principal risks to EM debt.36

Food inflation is another potential pressure point. Reuters reported an 81% chance of a very strong El Niño during October–December 2026, while higher energy and fertilizer costs and disruptions to grain shipments could intensify food-price risks in Asia and Latin America.1718 Morgan Stanley also noted that weaker rainfall could affect sugar-cane production in India, Thailand and Southeast Asia, with possible inflation and financial-market consequences.22

A food or energy shock can damage carry in two ways: it can weaken the target currency directly and force the local central bank to delay cuts—or even tighten policy—when investors were expecting easier conditions.

Brazil’s election and fiscal risk

Brazil has been one of the more rewarding carry markets, but that success also makes it vulnerable to position crowding. Bloomberg reported that election concerns were prompting some investors to reduce exposure to the Brazilian trade.19

For the real, a sufficiently sharp depreciation could overwhelm the interest earned on local assets. Brazil’s commodity exposure adds another layer: weaker Chinese demand, softer commodity prices or concerns about fiscal policy could all reduce support for the currency.1926

Commodity and technology repricing

Commodity-linked currencies such as the Brazilian real, Colombian peso and South African rand can benefit from strong commodity prices, but that support can reverse if global growth slows or China’s demand weakens. Research on 2026–27 commodity markets highlights both geopolitical and climate-related risks.20

A sharp correction in AI-linked Asian equities is another plausible risk channel because it could tighten financial conditions and trigger EM outflows. It should be treated as a scenario rather than an established current driver: the available research identifies AI and technology-cycle risk, but does not show that an AI reversal is presently the principal cause of EM-carry weakness.2836

The practical lesson from past unwinds

The 2008 crisis and the August 2024 episode were different events, but they share a useful lesson: carry trades can accumulate profits gradually and lose them abruptly when funding costs, volatility or risk tolerance reprice.464757

The rally therefore does not need a complete collapse in EM fundamentals to reverse. A relatively small change in the relationship between yield and currency risk can be enough. The most useful indicators to monitor are:

• US inflation, Treasury yields and Federal Reserve expectations;
• dollar and yen strength;
• EM implied FX volatility;
• the pace of EM policy-rate cuts;
• EM bond and currency fund flows;
• oil, fertilizer and food prices;
• Brazil’s fiscal and election headlines; and
• whether high-yield currencies continue to depreciate by less than their carry advantage.

Bottom line

Dollar-funded emerging-market carry had an exceptional 2025 because several favorable conditions arrived together: wide yield gaps, a weaker dollar, subdued volatility, resilient growth and strong investor demand. The trade remained viable into 2026, but its easy phase may be ending.

The most defensible outlook is selective rather than broad-based. Carry can continue to pay where real yields, policy credibility and external fundamentals are strong. But the strategy remains exposed to a familiar asymmetry: many months of steady income can be erased by one sharp move in the funding currency, local FX or global volatility.