USD Rally Pressures EMs; Diversified Funding Currencies Offer a Way Out

Overview

This research note explores how to optimize allocation strategies for Emerging Markets (EM) local currency assets against the backdrop of a current USD rally and strong US economic data. Morgan Stanley maintains a constructive outlook on EM local currency assets, citing attractive fundamentals and policy credibility, while acknowledging that the short-term strength of the USD presents significant headwinds. The core conclusion is that investors should not abandon EM exposure but rather isolate USD risk by 'changing funders' (i.e., diversifying funding currencies). Backtesting data shows that using a G3 currency basket or CAD as a funding currency can significantly enhance portfolio risk-adjusted returns.

Core views

Macro Environment and USD Headwinds: The divergence in economic growth trajectories between the US and other major economies, combined with persistently high energy prices and renewed expectations for Fed rate hikes, has driven up the USD. This 'American Exceptionalism' narrative has led investors to re-establish USD long positions and reduce exposures after covering some EM shorts. Although the report holds a long-term bearish view on the USD, its short-term strength indeed challenges EM performance, posing a risk of stagnant returns for EM long strategies reliant solely on USD funding. Fundamental Anchors and Regional Divergence: Despite external pressures, the underlying fundamentals of EM local currency assets remain robust. Excluding parts of Asia which continue to underperform, most EM countries have improved their monetary and fiscal credibility relative to developed markets. Regional performance varies significantly: Latin America is the only region recording positive returns in both duration and FX; Hungary stands out in the CEEMEA region with a YTD return of 16%; while Asian EMs lag, they have corrected significantly from yearly highs, releasing valuation pressure. Funding Currency Selection Strategy: Through backtesting data since 2010, the report finds that diversified funding outperforms single-currency approaches. Funding with an equal-weighted USD/EUR/JPY basket has generated stable total returns over the past 12 months and longer periods, with Sharpe ratios significantly higher and maximum drawdowns lower than pure USD funding. Among single currencies, CAD performs most均衡ly, with an annualized return of 3.6%, volatility of 6.3%, Sharpe ratio of 0.58, and a maximum drawdown of only -12.3% (compared to -28.8% for USD). While EUR funding performed best YTD, the basket strategy proves more robust over the long term. Capital Flows and Market Positioning: Capital flows into the EM local bond market have returned to neutral ranges following a sharp outflow in March, with YTD inflows matching those of the same period in 2025. FX options data show investors remain biased towards USD longs, yet constructive positions in EM currencies (such as Hungarian Forint, South African Rand, Polish Zloty) persist. This indicates the market has not completely abandoned EMs, but is waiting for clearer catalysts (such as falling oil prices or stability in global fixed income markets) to increase allocations.

Analysis framework

The report employs an analytical framework combining 'top-down macro judgment' with 'bottom-up quantitative backtesting'. First, by analyzing the growth differential between the US and non-US economies, energy prices, and central bank policy expectations, it establishes the macro background of short-term USD strength. Second, to verify the effectiveness of 'diversified funding', the team constructed backtesting models including single developed market currencies (USD, EUR, JPY, CHF, AUD, CAD) and various multi-currency baskets, examining cumulative returns, volatility, Sharpe ratios, maximum drawdowns, and Calmar ratios from 2010 to May 2026. This approach focuses not only on absolute returns but also on the stability of strategy performance across different market environments (including USD bull markets and non-USD bull markets), leading to the conclusion that basket funding and CAD funding possess statistical advantages.

Methodology notes

• Quantitative/Factor/Portfolio TheorySharpe / information ratio

  Application of Sharpe Ratio and Calmar Ratio in evaluating funding strategies

  When comparing different funding currencies, the report looks beyond absolute returns, placing emphasis on the Sharpe Ratio (measuring excess return per unit of total risk) and the Calmar Ratio (measuring the ratio of annualized return to maximum drawdown). This helps investors identify funding currencies that perform more robustly under extreme market stress (such as CAD and the G3 basket), even if their returns are not the highest, thereby avoiding the pitfall of chasing high yields while ignoring tail risks.

• Macroeconomic framework

  Logic of Funding Currency Selection and Growth Divergence

  The report treats 'funding currency' as an active risk management tool rather than a passive source of funds. When there is a growth divergence between the target asset (EMs) and the economy of the primary funding currency (USD), that funding currency itself becomes a negative Beta source. By switching to currencies with lower correlation to EMs or possessing defensive attributes (such as JPY, CHF, or commodity-linked CAD), investors can strip away unwanted USD macro risks, thereby purifying their investment exposure to EM fundamentals.

• Industry/Industrial Analysis FrameworkCapital Flow/Chip Analysis

  EM Capital Flow Tracker and Positioning

  The report constructs a local bond capital flow tracker covering 9 benchmark EM countries, estimating high-frequency foreign capital flows by adjusting for valuation and FX impacts. Combined with FX options positioning data, analysts can determine whether current market positions are crowded or cleared. For example, when rolling 3-month capital flows drop to neutral ranges and options show moderate increases in USD longs, it implies that EMs are not being excessively sold off, leaving room for potential future capital inflows.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• Canadian Dollar (CAD)

  Recommended funding currency for EM longs

  Strengths

  Historical backtests show it reduces volatility while enhancing returns; max drawdown is far lower than USD, JPY, and CHF; worst 3-month and 12-month performances are the best among single currencies.

  Weaknesses

  As a commodity currency, it may introduce additional correlation risk during periods of sharp fluctuations in global commodity prices.

  Comparison

  Sharpe ratio is 0.32 higher than USD funding; more stable long-term performance than EUR funding; lower left-tail risk than JPY/CHF.

  Risks

  If global energy prices crash sharply, CAD may depreciate significantly, weakening its hedging effect as a funding currency.

• G3 Currency Basket (USD/EUR/JPY)

  Recommended diversified funding benchmark solution

  Strengths

  Demonstrates higher Sharpe ratios and lower drawdowns than single USD across multiple time horizons (1yr, 3yr, 5yr, full sample); disperses risk associated with single monetary policy cycles.

  Weaknesses

  Implementation costs are slightly higher than single currency; requires periodic rebalancing.

  Comparison

  Sharpe ratio is only slightly lower than the pure EUR funding strategy which performed best YTD, but is more robust; significantly superior to broad DM baskets including AUD/CHF.

  Risks

  Diversification effects may weaken if G3 central banks tighten or ease monetary policy synchronously.

• Hungarian Forint (HUF)

  Preferred long position in the CEEMEA region

  Strengths

  YTD return rate of 16%, leading EMs; although the central bank paused rate cuts, it signaled dovishness, leaving room for risk premium compression; long-end rates have further convergence potential relative to Polish Zloty.

  Weaknesses

  Sensitive to external financial conditions; if global oil price shocks cause inflation rebound, the central bank may be forced to pivot.

  Comparison

  Performance significantly优于 Polish Zloty and Turkish Lira in the same region; particularly outstanding given the overall EM return of only 1%.

  Risks

  Global oil price surge triggering secondary inflation uptick; EU fund disbursement progress falling short of expectations.

• Mexican Peso (MXN)

  Tactical opportunity in credit and FX

  Strengths

  Hard currency bond pricing already implies two downgrades, making valuations highly attractive; base case assumes no actual downgrade in 2026; central bank's restrictive stance provides support.

  Weaknesses

  Uncertainty brought by USMCA renegotiation; as a global growth hedge, downside risk is highest in LatAm; the rate cut cycle has begun to erode carry appeal.

  Comparison

  Compared to Brazilian Real, Mexican sovereign debt is cheaper valued with lower fiscal risk; less directly impacted by geopolitical conflicts compared to Chile.

  Risks

  Pessimistic scenario in USMCA negotiations; sharp rise in US interest rates.

Key data

• EM vs CAD Sharpe Ratio (2010-2026)0.58Highest among single funding currencies, approaching the level of the optimal basket strategy
• EM vs USD Max Drawdown-28.8%Significantly higher than CAD (-12.3%) and G3 Basket (-13.6%)
• Hungary (HUF) YTD Return16%Best performing among EM local currency assets
• EM Local Bond YTD Total Return~1%Retraced gains after peaking in late February, currently at low levels
• Rolling 3-Month Capital Flows~-$20bnReceded from +$40bn in mid-February, primarily due to calculation windows for prior inflow/outflows, not indicative of new massive outflows

Impact & implications

For investors allocating to EM assets, the report's advice implies a need to re-examine the 'liability side' of portfolios. During periods of cyclical USD strength, simply going long on EM local currency assets may erode coupon yields due to FX losses. By switching funding currency from pure USD to a G3 basket or CAD, investors can effectively reduce portfolio volatility and drawdown risk while retaining EM Alpha. Additionally, regional differentiation is crucial: LatAm and specific CEEMEA countries (like Hungary) offer better risk compensation, while Asian markets may require more patience for catalysts. For countries like Mexico and Colombia affected by elections or trade agreements, close monitoring of short-term pricing deviations caused by political events is essential.

Risks

• USD strengthens further significantly due to continued US economic outperformance or unexpected Fed rate hikes
• Global energy prices remain high or continue to rise, worsening EM trade conditions and inflation outlook
• Election results in key countries (e.g., Colombia, Peru) deviate from orthodox policy paths, triggering asset repricing
• Negative progress in USMCA renegotiation, impacting Mexican assets
• EM capital flows fail to recover as expected, leading to liquidity crunches

What to watch

• Impact of US employment and inflation data on Fed policy expectations
• Global crude oil price trends and their transmission to energy-importing countries (e.g., India, Turkey)
• Polling and endorsement dynamics in the second round of Colombian elections
• Whether monthly capital flows into EM local bonds turn positive
• Interest rate decisions and forward guidance from major EM central banks (e.g., Hungary, South Africa, Poland)