How a Hawkish Fed, a Surging Dollar, and the Iran Oil Shock Are Crushing EM Carry Trades

A hawkish Fed under Kevin Warsh: Rate cuts are dead, hikes are live

The most dramatic change across 2026 has been the market’s repricing of the Federal Reserve’s rate path. As recently as late February, futures markets were fully pricing in two rate cuts before year-end. By May, markets had swung to pricing an approximate 67% chance of a Fed rate hike by April 2027—a complete reversal driven by sticky inflation and the energy price surge from the Iran war . A majority of the futures market now expects at least one 25-basis-point hike before the end of 2026, according to CME FedWatch .

New Fed Chair Kevin Warsh, who took office in May, has so far reinforced that hawkish shift. His first week signaled a more rules-based, hawkish approach than markets anticipated . Warsh has publicly stated that inflation is “not headed in the right direction” and has backed removing the easing bias from the Fed’s policy statement . He inherits a committee that had already moved in a hawkish direction: the April FOMC statement edged toward a neutral-to-hawkish bias after holding rates at 3.5–3.75% . Multiple Fed officials have signaled openness to rate hikes if elevated inflation persists .

For EM carry, a hawkish Fed is a direct threat. Higher US rates increase the attractiveness of dollar-denominated assets and raise the cost of dollar borrowing—a double blow for EM currencies that rely on yield-seeking capital flows.

The dollar’s comeback: Why the carry trade’s biggest ally is now its enemy

A weaker dollar was the foundational assumption behind this year’s bullish EM carry calls. Many forecasters projected mild dollar depreciation throughout 2026, pointing to front-end yield compression and a supportive environment for EM FX . Carry strategies were up 1.3% year-to-date by late January 2026 as investors piled into currencies from Brazil, South Africa, and Egypt .

That assumption has broken down dramatically. The dollar has strengthened on expectations of continued Fed patience on inflation and potential hikes . State Street Global Advisors described the dynamic in April: escalating war risks and energy disruptions are reinforcing dollar strength, with a higher probability of sustained dollar strength over one to two quarters . The dollar’s strength directly undermines EM carry returns because even a modest depreciation in high-yielding EM currencies can wipe out the interest-rate advantage in a matter of weeks.

The Strait of Hormuz shock: Geopolitics as an accelerant

The final element in the squeeze is the US-Iran war and the effective closure of the Strait of Hormuz, through which about 20% of global oil trade normally passes . The conflict began on 28 February 2026 and has resulted in the largest oil supply disruption in modern market history, with roughly 20 million barrels per day taken offline . The International Energy Agency has characterized the crisis as the largest disruption in the history of oil markets, with director general Fatih Birol describing its combined impact as equivalent to the 1973 oil crisis and the 2022 energy shock combined .

This energy shock feeds back into the EM carry squeeze through multiple channels:

• Inflation: Higher oil prices have pushed US inflation back toward 4%, keeping the Fed vigilant and making rate cuts impossible for the foreseeable future .
• Dollar strength: A sustained oil supply shock reinforces the dollar’s safe-haven bid, a dynamic that State Street explicitly flagged in shifting its USD outlook to neutral from negative .
• EM vulnerability: EM economies that are heavy energy importers face widening current-account deficits and rising financing needs, putting their currencies directly in the crossfire . Higher oil prices simultaneously weaken their trade balances while strengthening the US dollar—exactly the opposite of what a carry trade needs.

The situation remains fluid. An April ceasefire briefly raised hopes that some of the disruption would reverse, but renewed clashes and the uncertain status of US-Iran negotiations mean the Strait of Hormuz remains a live risk . If the disruption continues, CICC has warned that Brent crude could exceed $120 per barrel, forcing a huge drawdown of global inventories and putting even more pressure on EM economies .

How the squeeze hits EM carry in practice

The table below shows how the fundamental conditions for EM carry have deteriorated since the start of the year.

The shift is dramatic. In late 2025, major managers were actively extending EM carry positions into 2026, expecting the combination of a dovish Fed and low volatility to keep the trade profitable . By mid-2026, those assumptions had been replaced by a regime of Fed hike risk, dollar strength, and the most severe energy crisis in decades.

Critical caveats and what could change the picture

The outlook for EM carry is not set in stone. Several factors could ease the pressure:

• If the Strait of Hormuz disruption is resolved through a sustained ceasefire, part of the oil shock could reverse, easing inflation pressures and potentially weakening the dollar .
• The Warsh Fed is still in its early days. While market pricing reflects a hawkish outlook, actual policy decisions will depend on the path of inflation and the economy. Some analysts still argue that labour market downside risks are being underweighted and that rate cuts remain possible by late 2026 .
• EM carry is not a monolithic trade. Currencies with strong fundamentals, large rate cushions, and limited energy import exposure may hold up better than the broader asset class suggests.

The bottom line is that EM carry has moved from a supportive soft-dollar, low-volatility environment into a much more threatened position. The combination of a hawkish Fed under Kevin Warsh, a strengthening dollar, and a major oil shock centered on the Strait of Hormuz is structurally hostile for the trade. Resolution of the energy crisis could offer some relief, but for now, the squeeze is tightening.