Why a sideways dollar isn’t the end of the emerging markets story

The dollar’s structural downcycle is far from over, but investors expecting another sustained leg lower may be disappointed. Two of the biggest obstacles to dollar weakness sit not in Washington, but in Paris and Beijing. Political instability in France threatens to constrain the euro, while China’s preference for a gradual appreciation of the renminbi could hold back Asian currencies. Together, these forces could keep the dollar trading sideways over the next 12 months.

For emerging markets, the distinction matters. A weaker dollar has historically been a powerful driver of returns. Capital flows into non-US assets can reinforce this dynamic, which is why emerging market bull markets have often coincided with dollar downcycles.

Last year, in our paper on dollar cycles, The unstoppable dollar meets the immovable Mr Trump, we argued that the dollar’s 14-year upcycle was ending. The dollar is down 6.8 per cent from its 2025 peak in real trade-weighted terms.¹ Tariffs and inconsistent US policy on Ukraine lifted European and Japanese defence spending, narrowing interest rate differentials. Wider US fiscal deficits, pressure on the Federal Reserve and increased currency hedging have also contributed.

France: political instability caps the euro

The euro is more than half of the US Dollar Index (DXY) and the largest weight in the Federal Reserve’s broad trade-weighted measure. A sustained decline in the dollar typically requires a stronger euro, and uncertainty over France’s public finances may limit demand for the euro.

Prime Minister Sébastien Lecornu’s minority government presented its 2027 budget in early October with 10-year French government bond (OAT) yields near 5 per cent, the highest since 2002. The spread over German Bunds, which sat between 30 and 45 basis points (bp) from 2014 to 2022, recently touched 160bp before settling around 135 to 140bp.

Parliament votes in mid-November, amid a febrile political atmosphere. The scenes on the streets of French cities and towns over the weekend have taken place before austerity has even begun. The market is rightly questioning public consent of an austerity programme that it deems necessary. If the budget fails, the most likely outcome is a special law rolling over this year’s budget, as when Michel Barnier’s government fell in December 2024. That implies a 2027 deficit above 6 per cent, for a country where nominal gross domestic product (GDP) is growing at under 3 per cent a year. If the budget passes, it is only a holding operation, with no guarantee that the next one will.

The bigger risk comes after the budget. Presidential elections in April and May 2027, followed by legislative elections in June, could produce another hung assembly. France would then have a new president, but no parliamentary majority or durable budget, extending uncertainty into 2028.

Would the European Central Bank (ECB) step in? Ultimately, yes. France is too big to fail, and the ECB has stronger tools than it did during the euro crisis. However, the ECB is unlikely to act until the OAT-Bund spread gets well above 200bp, and likely 250bp, and stress has spread to Italy and Belgium. Until then, French risk will weigh on the euro.

China: setting the pace for Asian currencies

The other route to a weaker dollar runs through East Asia. Past dollar downcycles have been helped by a large surplus currency appreciating: the yen after the 1985 Plaza Accord, and the renminbi after China loosened its strict dollar peg in 2005. The renminbi is the obvious candidate again. The International Monetary Fund puts its undervaluation at about 20 per cent, and some estimates suggest 30 per cent.

It has gained about 4 per cent against the dollar this year, but the People’s Bank of China has leaned against faster gains, most recently on 8 October. Because much of Asian foreign exchange is correlated with the renminbi, a managed yuan caps a large part of the emerging market currency universe too.

Beijing has little reason to hurry. Gross debt stands at around 300 per cent of GDP, while interest payments are rising relative to output. Unlike 1980s Japan, China does not depend on a foreign security guarantee, and it controls its own supply chains. It may let the renminbi rise gradually, on its own terms and in the service of internationalising the currency. A rapid move towards fair value looks unlikely.

Europe’s tougher trade stance adds pressure, including the Macron-Merz non-paper of 5 October on a rapid-response trade instrument. But Beijing has promised a firm response.

Why the downcycle remains intact

Dollar downcycles take time: The last three (the 1970s, 1985 to 1995 and 2002 to 2011) each ran for roughly eight to twelve years, with consolidations and sharp counter rallies. Three structural pressure points remain.

Concentration: US companies account for around 65 per cent of the MSCI All Country World Index (ACWI), up from about half a decade ago. This leaves global portfolios heavily exposed to the dollar, creating incentives to diversify. Even a modest shift at the margin moves the currency.

Hedging: After the April 2025 tariff shock, when the dollar fell alongside US equities, foreign investors raised hedge ratios. This year, artificial intelligence (AI) flows and a hawkish Federal Reserve let them drift lower again. Bloomberg estimates that a five-point rise in hedge ratios across six major investor markets would mean over US$200 bn of dollar selling.

The next US-specific shock, whether political, monetary or AI-related, could remind investors that the dollar carries two-way risk. The Korean won and the Taiwanese dollar remain cheap and could strengthen reflexively with repatriation.

Diversification. Central banks have bought gold since Russia’s reserves were frozen in 2022, more trade is settled in local currencies, and Beijing keeps pushing renminbi internationalisation. None of this dethrones the dollar, but it erodes marginal demand year after year.

Beyond these three pressure points, an AI spending slowdown could be a particularly powerful catalyst. Given the concentration of global portfolios in US technology companies, disappointing returns on AI investment could trigger capital outflows and renewed currency hedging, accelerating dollar weakness. A broader global risk-off shock, however, could still support the dollar through safe-haven demand.

What this means for emerging market investors

A sideways dollar raises the importance of selectivity but does not diminish the opportunity. Improving domestic fundamentals, attractive valuations and opportunities across equities and fixed income offer sources of return beyond currency appreciation. The MSCI Emerging Markets Index trades at about 9.9x forward earnings, less than half the S&P 500’s multiple of more than 20x, the widest gap in at least two decades².

The dollar’s structural downcycle remains intact, even if the next 12 months bring a pause. For emerging markets, the opportunity is broader than the direction of the dollar.

1. Source: Federal Reserve Board, Real Broad Dollar Index, as at 30 September 2026.
2. Source: Bloomberg, "Emerging-Market Stock Valuations Sink Below Half of S&P 500’s".