The five-year dollar story investors are missing

A fair exchange

Despite an extremely weak 2025, dollar indices are still sitting in the upper quartile of their historical range. The currency remains expensive, and past cycles suggest that typical troughs occur when valuations are roughly 25% lower in real terms than today.

Looking back, the dollar hasn’t stayed this elevated for long. But we would caution against treating this indicator as an automatic signal of imminent weakness. Instead, the real exchange rate tells us something more important: over a five‑year horizon, the dollar is likely to remain at a higher‑than‑average valuation, and real currency moves are unlikely to be a major risk factor in returns.

That said, there’s still plenty of room for depreciation if the US economy slows relative to the rest of the world or US interest rates fall faster than their equivalents. In other words, while the real exchange rate doesn’t force dollar weakness, the macro backdrop could easily deliver it.

Keeping it real

Real yields tell us what investors can earn even if the dollar doesn’t weaken. And because we’ve already looked at real exchange rates, we keep the analysis consistent by using real yields here too – ensuring inflation is captured on both sides.

Today, short‑term emerging‑market (EM) real interest rates are around 1-2 percentage points higher than they were through most of the 2010s. In contrast, US short‑term rates sit at roughly 1% above inflation. That means investors earn three times as much real yield in the average EM market as they do in the US.

For real dollar appreciation to fully erase that advantage over a five‑year horizon, we would need to move into uncharted territory. And if the dollar depreciates instead, the return profile becomes even more compelling.

What about the Fed?

In our view, the US Federal Reserve’s (Fed) response to inflation will be asymmetric. If inflation rises modestly, we don’t expect rate hikes to match the increase – leaving real rates lower. If inflation falls – and our house view sees CPI at 2.1% year‑on‑year by year‑end, from 2.7% today – the Fed is likely to cut rates at least twice. That would leave US real rates flat or lower again.

Shifts in short‑term rate expectations – markets currently price in two cuts over the next year – will create some currency volatility. But they don’t change the big picture: EM real yields still offer a materially stronger starting point.

On the markets

The case for taking some currency risk – moving out of US fixed income and into EM equivalents – looks convincing. The combination of elevated dollar valuations and materially stronger EM real yields creates a favourable five‑year risk‑reward backdrop.

On the policy front, US President Trump’s nomination of Kevin Warsh to lead the Fed has washed out some of the speculative positioning around expectations of a more unambiguously dovish appointment. Precious metals and currencies have softened in response, but interest‑rate pricing has barely shifted.

Against this backdrop, we remain comfortable using dollars to fund long EM local‑currency debt positions. The structural yield advantage is intact, and nothing in recent policy signals materially changes the picture.

One final point: capital flows

Before turning to the implications for EM debt investors, it’s worth briefly considering capital flows. Some investors are trimming dollar exposure due to policy volatility, fiscal concerns and stretched equity valuations, and we can see hints of this in enquiries and flow data. The macro implications are limited – as long as the US runs a current account deficit, overseas capital will still flow into US assets – but the income balance has shifted.

A strong dollar and higher US interest rates have reduced the historical profitability gap between US investments abroad and foreign investments in the US. If this trend persists, further dollar appreciation could push the US into a negative foreign‑income position – a backdrop that rarely supports sustained, multi‑year dollar strength.

What does this mean for emerging‑market debt investors?

For EM debt investors, the implications are clear. Elevated dollar valuations, stronger EM real yields and potential asymmetric Fed response suggest favourable conditions for EM local‑currency debt. Real carry remains a powerful return driver, and the dollar does not need to weaken to justify exposure – though a weaker dollar would amplify returns.

In this environment, we believe EM investors can lean into local‑currency opportunities, especially in markets where inflation has normalised, policy cycles have peaked and real yields remain structurally attractive. Selectivity still matters, but the combination of improved fundamentals, high real carry and a less one‑way dollar makes this an environment where EM fixed income can play a more central role in global portfolios.