Emerging-market carry traders are progressively shifting from the US dollar to alternative funding currencies, including the euro and the Australian dollar, as the greenback strengthens. Bloomberg reported this tactical pivot on July 5, 2026, driven by soaring dollar borrowing costs and shifting interest rate expectations. The move represents a significant departure from the long-established dollar-dominated funding model for bets in developing economies.
Context — [why this matters now]
The US dollar has roared back in 2026, with the DXY Index climbing over 8% year-to-date by early July. This rally pushed dollar funding costs to multi-year highs, eroding the profitability of traditional dollar-funded carry trades into high-yielding emerging market assets. The primary catalyst is a repricing of Federal Reserve policy, with markets now expecting fewer rate cuts than projected at the start of the year.
This shift mirrors a similar dynamic observed in late 2021 when the dollar began a prolonged uptrend. During that period, traders also briefly explored funding in euro and yen to maintain positive carry. The current environment is more pronounced due to the magnitude of the dollar's move and the explicit divergence in central bank policy paths between the Fed and other major banks.
The European Central Bank's more dovish stance relative to the Fed created the necessary interest rate differential. Similarly, the Reserve Bank of Australia's data-dependent approach offers a lower and more stable volatility profile compared to the dollar, making the Aussie an attractive funding alternative for risk-sensitive strategies.
Data — [what the numbers show]
Specific data illustrates the shift in funding preferences. The three-month EUR/USD cross-currency basis swap tightened to -15 basis points in early July from -25 bps in April, indicating increased demand to borrow euros. Implied volatility on one-month AUD/JPY, a popular proxy for risk-on carry trades, fell to 8.5% from 11.2% two months prior.
The cost of borrowing dollars via three-month FX swaps rose sharply. The implied yield for a Brazilian real-funded trade using dollars increased by 120 basis points in the second quarter. In contrast, the same trade funded in euros saw a cost increase of only 70 bps over the same period.
Brazilian real one-year IRS rates trade at 10.25%, compared to the European Central Bank's deposit rate of 3.25%. This creates a 700 basis point positive carry for euro-funded positions, a spread that has expanded by 80 bps since January. The South African rand and Mexican peso also offer yields above 9.5%, maintaining their attractiveness for funded positions.
Analysis — [what it means for markets / sectors / tickers]
This rotation impacts currency volatility and liquidity. EUR/JPY and AUD/JPY pairs are experiencing higher volumes and lower volatility as they become new funding vehicles, while dollar pairs like USD/ZAR may see increased volatility from reduced hedging flow. European and Australian short-dated government bonds, particularly German Schatz and ACGB futures, face upward pressure as traders sell them to fund emerging market purchases.
A key risk is that this shift remains tactical rather than structural. A sudden reversal in dollar momentum could see traders rapidly unwind these new funding positions, creating whipsaws in euro and Aussie crosses. The euro's status as a funding currency is often tenuous and can quickly reverse during periods of European-specific stress.
Positioning data from CFTC shows asset managers and leveraged funds have increased short positions in euro and Aussie futures. Flow data indicates net selling in EUR/USD on rallies toward 1.0850 and buying interest in AUD/USD near 0.6550, levels that have become technical anchors for these new carry dynamics.
Outlook — [what to watch next]
The sustainability of this trend hinges on two near-term catalysts. The US CPI release on July 11 will dictate the Fed's future path and the dollar's momentum. The ECB meeting on July 17 is critical for confirming the maintenance of its dovish stance, which underpins the euro's appeal as a funding currency.
Traders are monitoring key technical levels. A break in the DXY above 108.50 could accelerate the shift into alternative funding currencies. Conversely, a drop below 105.00 on the DXY would likely trigger a rapid unwind of these new positions. The 10-year Bund yield holding below 2.5% remains essential for keeping euro funding costs attractive.
The Reserve Bank of Australia's meeting minutes on July 16 will be scrutinized for any hint of a hawkish pivot that could diminish the Aussie's funding appeal. Australian economic data, particularly employment figures, will directly influence the cost and stability of using the currency for carry trades.
Frequently Asked Questions
What is a carry trade in emerging markets?
A carry trade involves borrowing in a low-yielding currency to invest in a higher-yielding asset, profiting from the interest rate differential. In emerging markets, traders traditionally borrowed US dollars to buy high-yielding local bonds in countries like Brazil, Mexico, or South Africa. The risk is that currency moves erase the profit from the interest rate difference.
How does a stronger US dollar affect emerging markets?
A stronger dollar typically creates pressure on emerging markets. It increases the debt servicing costs for countries and corporations with dollar-denominated debt. It can also trigger capital outflows as dollar strength reduces the relative attractiveness of riskier EM assets, often leading to underperformance in EM equities and currencies versus developed market counterparts.
What are the risks of using the euro for funding instead of the dollar?
The euro has historically been a less reliable funding currency than the dollar. Political instability within the Eurozone or a sudden hawkish shift from the European Central Bank can cause the euro to appreciate rapidly, making it more expensive to repay borrowed funds. This introduces a different type of volatility and political risk into the carry trade equation.
Bottom Line
Dollar strength is forcing a structural rethink of how carry trades are funded, benefiting euro and Aussie liquidity.
Disclaimer: This article is for informational purposes only and does not constitute investment advice. CFD trading carries high risk of capital loss.
