Dovish Fed and Cautious EM Policymakers Fuel Carry Trade Renaissance

Emerging market currencies have gained against the U.S. dollar at decade-best rates in 2025, driven by a combination of dovish U.S. monetary policy expectations and cautious stances from central banks in developing economies. According to Citi’s head of emerging-market strategy, Luis Costa, the current trend in carry trades—where investors borrow in low-yielding U.S. dollars to fund higher-yielding emerging market assets—has delivered some of the most attractive returns of the past decade. The Bloomberg index, which tracks the performance of such trades across eight emerging markets, has risen by more than 10% this year, marking the strongest annual performance since 2017.

Costa attributes this performance to a Federal Reserve that has increasingly adopted a dovish tone, which has weakened the dollar against alternative currencies. At the same time, emerging market central banks have maintained a broadly neutral policy stance, which has helped to sustain the appeal of those markets. The continued caution among EM policymakers is seen as a stabilizing factor, supporting real policy rates and making the carry trade more attractive. In addition, market expectations are leaning toward further easing by the Fed in 2026, reinforcing the trend.

The Brazilian real has emerged as a standout performer among emerging market currencies, gaining more than 20% against the dollar this year. This strong performance has been bolstered by the market's perception of a cautious and predictable monetary policy from Brazil’s central bank. The real’s appreciation reflects not only the strength of EM currencies relative to the dollar but also the broader appeal of carry trades in a low-yield U.S. environment. Citi remains bullish on the real, with analysts expecting that the currency will continue to benefit from a dollar that is struggling to hold its value amid U.S. trade policy uncertainty.

The dollar’s decline has been significant, with the Bloomberg Dollar Spot Index dropping 7.8% this year. Concerns over aggressive U.S. tariffs and their implementation have raised questions about the dollar’s long-term stability as the world’s reserve currency. Some investors and analysts, including those at HSBC Holdings Plc, have warned that the dollar’s current weakness may be a sign of an overextended market, with the risk of a sharp reversal in the near future. However, Costa emphasizes that the current conditions remain favorable for emerging market currencies, even as he cautions that the outlook could become more challenging in the second half of 2026.

Looking ahead, Citi’s analysts are also exploring other currency pairs for potential gains, including the Turkish lira. While the current momentum in EM currencies appears strong, the firm has highlighted the risks of a U.S. economic rebound driven by loose financial and fiscal policies. In such a scenario, the dollar could strengthen, and the carry trade environment may become less favorable for emerging market assets. As global investors continue to shift capital in response to evolving monetary policies and trade dynamics, the performance of EM currencies will remain closely watched for signs of sustainability or reversal.

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[1] Citi Says Biggest Carry Trade Rally in Years Has Longer to Run (https://www.bloomberg.com/news/articles/2025-08-20/citi-says-biggest-carry-trade-rally-in-years-has-longer-to-run)

[2] Citi diz que o maior rali de carry-trade em anos deve continuar (https://www.bloomberg.com/news/articles/2025-08-20/citi-diz-que-o-maior-rali-de-carry-trade-em-anos-deve-continuar)

[3] 1 USD to BRL - US Dollars to Brazilian Reais Exchange Rate (https://www.xe.com/currencyconverter/convert/?Amount=1&From=USD&To=BRL)

[4] Brazilian Reals to U.S. Dollar Spot Exchange Rate (DEXBZUS) (https://fred.stlouisfed.org/series/DEXBZUS)