Dollar Strength 101: Diverging Growth, Real Yields, and the Feedback Loop into EM FX

The U.S. dollar has emerged as a pivotal force in global markets as of September 2025. Its strength is not just a simple occurrence; it reflects the intricate interplay of diverging growth trajectories, real interest rates, and a significant feedback loop impacting emerging market currencies (EM FX).

Diverging Economic Growth

Economic data painted a mixed picture across the globe, with the United States showcasing robust growth, particularly post-pandemic recovery. The U.S. economy grew by 3.5% in the second quarter of 2025, buoyed by consumer spending and a resurgence in manufacturing due to increased automation and supply chain resilience.

In contrast, many emerging markets, particularly in Latin America and parts of Asia, are grappling with slower growth rates. Brazil, for instance, reported only a 1.8% growth in the same quarter, hindered by high inflation and political instability. Similarly, India's growth, though relatively strong at 5%, faces headwinds from rising commodity prices and challenges in its agricultural sector.

This stark divergence underscores why the U.S. dollar is gaining strength. As investors prioritize safety and returns, they increasingly favor dollar-denominated assets, leaving emerging market currencies more vulnerable to depreciation.

Rising Real Yields

The strength of the dollar is closely linked to real yields in the U.S. Following the Federal Reserve's signal for a cautious tightening approach in mid-2025, real yields have been on the rise. The 10-year Treasury yield has climbed to 3.8%, the highest in over a decade, while inflation rates moderated to around 2.4%.

This creates a favorable environment for U.S. dollars as yields remain attractive compared to other currencies. In contrast, many emerging economies are struggling with negative real yields due to persistent inflation rates. For example, Argentina is facing a staggering inflation rate of 95%, rendering its real yield deeply negative, which puts immense downward pressure on the Argentine peso.

Thus, with higher real yields in the U.S., capital continues to flow from emerging markets to the safety of the dollar, reinforcing its strength.

The Feedback Loop into EM FX

The constant flow of capital into the dollar creates a feedback loop that further exacerbates the challenges faced by emerging market currencies. As the dollar strengthens, emerging market currencies lose value against it, prompting central banks in these regions to intervene or raise interest rates to stabilize their currencies.

During the recent quarter, several central banks in emerging markets, including the South African Reserve Bank and the Bank of Brazil, announced unexpected interest rate hikes to combat currency depreciation. However, raising rates comes with its own set of risks, including slowing domestic growth and increasing debt burdens.

For instance, the South African rand has depreciated by over 15% against the dollar since the beginning of 2025, prompting the SARB to increase its benchmark interest rate by 75 basis points in August. Such measures may provide temporary relief but can also stifle economic growth and lead to political unrest in the affected regions.

Investment Strategies in a Strong Dollar Environment

Investors are finding ways to navigate this dollar strength by reassessing their allocation strategies in a global context. Generally, sectors exposed to commodities may face headwinds while U.S.-focused equities benefit from domestic growth trends.

Furthermore, international investors are becoming more selective about emerging market investments. Dual currency bond issuance, where bonds are offered in both local and U.S. currency, has gained traction. This strategy allows investors to hedge against currency risk while gaining exposure to higher yields.

As reported by Bloomberg in September 2025, international demand for U.S. dollar-denominated debt from emerging markets rose by 30% in the last quarter, reflecting how impatient capital is seeking refuge amid an increasingly complex global landscape.

The Geopolitical Landscape and Its Impact

Geopolitical tensions have also played a critical role in dollar strength. Increased U.S.-China tensions have fuelled a 'risk-off' sentiment among investors, prompting them to flock to safe havens like the U.S. dollar. This phenomenon has contributed to volatility in commodities, particularly oil, which recently approached $100 per barrel again amid OPEC production cuts and geopolitical uncertainties.

Additionally, the Middle Eastern geopolitical landscape remains tense, with developments in Iran and Iraq causing volatility in oil prices that impacts exchange rates further afield. The relationship between these dynamics shows how interconnected the dollar is to global events, reinforcing its status as the world’s reserve currency.

The Path Forward

Given the current outlook, the dollar’s strength seems likely to persist as diverging growth remains a primary theme. Emerging markets may need to navigate through a challenging landscape characterized by fluctuating capital flows, rising real yields, and geopolitical uncertainties.

For businesses and investors, the focus should remain on strategies that hedge against currency risks and align with global growth themes. The complex interplay of growth, yields, and international political considerations will remain key in the ongoing narrative of dollar strength and its impact on emerging markets.