Dollar Weakness Creates an Opportune Moment for Emerging Markets Debt

The recent weakening of the US dollar, following a decade-long period of strength, has created a significant tailwind for emerging markets (EM) debt. This shift comes at an opportune time: the asset class has grown more resilient in recent years, as many EM economies have strengthened their balance sheets and returned inflation to target. Combined with higher yields across both hard and local currency debt, the environment offers an attractive investment proposition.

For active managers, the backdrop is particularly favorable. A weaker dollar enhances the appeal of local currency EM debt, while also continuing to support hard currency debt — providing opportunities across the broader EM universe. 

Why the dollar is vulnerable 

Several factors support the further depreciation of the US dollar — conditions that historically have been favorable for emerging markets debt, particularly EM local currency assets. Four key drivers underpin our view:

• Valuation: By most metrics, the US dollar is trading at elevated levels relative to historical norms. This overvaluation suggests limited upside and increases the risk of mean reversion, especially in an environment where structural supports for dollar strength are eroding. 
• Positioning: Investor positioning is heavily skewed toward the dollar. A shift in sentiment or fundamentals could lead to a broad-based reallocation away from the dollar and into undervalued currencies, including those in EM. 
• Fundamentals: The US is running substantial twin deficits (fiscal deficit and current account). With deficits widening even in a low unemployment environment — exacerbated by recent fiscal packages — long term vulnerabilities weigh on the dollar. 

As you can see in exhibit 1, even with the US at full employment and unemployment below 4%, the fiscal deficit is running at about 6% of GDP. That divergence is unsustainable. Furthermore, with the passage of the latest fiscal package — the One Big Beautiful Bill Act (OBBBA) — the deficit is set to widen even further over the next few years. This fiscal trajectory is likely to put sustained pressure on the dollar.

• Policy outlook: The US administration has shown little resistance to a weaker dollar, removing a key support for the currency. Additionally, expectations that the Federal Reserve will resume its rate-cutting cycle this year further erode a critical pillar underpinning dollar strength.

Together, these drivers point to continued dollar weakness — an environment that supports both EM hard and local currency bonds, as illustrated in exhibit 2. A weaker dollar generates beneficial secondary effects for EM assets. It allows many countries to build higher foreign exchange reserves, which provide buffers against global volatility and help stabilize local currencies. It also reduces the cost of servicing hard currency debt, easing fiscal pressures. In addition, a softer dollar tends to lift commodity prices, which is especially supportive for commodity-exporting EM economies. Taken together, these effects strengthen what is already a supportive global backdrop for EM. 

EM fundamentals are stronger 

Since the pandemic, many emerging market countries have made significant progress in strengthening their economic foundations. Balance sheets have improved, fiscal consolidation is underway — aimed at reducing deficits and ensuring long-term sustainability — and current account balances are strong.

Additionally, inflation has returned to target ranges in most EM economies as a result of prudent and proactive monetary policy over the last few years. With inflation under control, many EM central banks have been able to commence their easing cycles, providing an additional tailwind for investing in local rates and reinforcing the investment case for EM debt. 

Elevated yields present attractive entry points 

At the same time, yields in both hard and local currency remain at elevated levels, offering attractive entry points for investors. For example, hard currency yields are currently trading above historical medians. Historically, when starting at similar yield levels, the asset class has delivered a median annual return of around 10% over five-year periods. In today’s market, investors are positioned to benefit not only from higher yields, but also from diversification and the tailwind of improving macroeconomic fundamentals across emerging economies.

Summary 

The combination of dollar weakness, stronger EM fundamentals, and elevated yields creates a uniquely favorable environment for emerging markets debt. We believe both hard and local currency segments are well placed to deliver attractive, risk-adjusted returns, presenting a compelling opportunity for investors.  

Important Risk Considerations: 

Emerging markets can have less market structure, depth, and regulatory, custodial or operational oversight and greater political, social, geopolitical and economic instability than developed markets.

Investments in debt instruments may decline in value as the result of, or perception of, declines in the credit quality of the issuer, borrower, counterparty, or other entity responsible for payment, underlying collateral, or changes in economic, political, issuer-specific, or other conditions. Certain types of debt instruments can be more sensitive to these factors and therefore more volatile. In addition, debt instruments entail interest rate risk (as interest rates rise, prices usually fall). Therefore, the portfolio's value may decline during rising rates.

The views expressed are those of MFS, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any MFS investment product. Unless otherwise indicated, logos and product and service names are trademarks of MFS^® and its affiliates and may be registered in certain countries.

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