Monetary Policy Divergence
When major central banks like the Federal Reserve or the ECB alter interest rates at different speeds or magnitudes, it creates Monetary Policy Divergence. This divergence heavily impacts exchange rates via the Uncovered Interest Rate Parity (UIP) condition:
$$ (1 + i_t) = (1 + i_t^*) \frac{E_t^e}{E_t} $$
Where $i_t$ is the domestic interest rate, $i_t^*$ is the foreign rate, $E_t$ is the spot exchange rate, and $E_t^e$ is the expected future exchange rate. If US rates rise relative to emerging market (EM) rates, capital flows into the US seeking higher yield, causing the EM currency to depreciate.
The Emerging Market Dilemma
Emerging markets face a trilemma. If they raise rates to defend their currency, they risk crushing domestic growth. If they keep rates low, capital flight depreciates their currency, causing imported inflation and making USD-denominated debt harder to service (the original sin of sovereign debt).