Currency Volatility Set to Wipe Out Emerging-Market Carry Trades
Matthew Burgess and Prima Wirayani
5 min read
(Bloomberg) -- Emerging market investors are turning increasingly wary of carry trades as the threat of tariffs from the Donald Trump administration and the prospect of further dollar gains squeeze returns.
Latin American currencies, often bought as part of such trades, face pressure from domestic fiscal issues along with the prospect of trade tensions with the US, according to Mackay Shields and Pictet Asset Management. Carry trades involve borrowing in currencies from countries with relatively-low interest rates, like the yuan or yen, and investing those funds in markets with higher rates.
Yen-funded trades are vulnerable as it’s more attractive to invest in Japan, Robeco Group said, with the local central bank on a rate-hike trajectory. The risk of a stronger dollar is also reducing the greenback’s appeal as a funding currency, the asset manager said, as the threat of rising inflation from Trump’s policies comes in the way of further interest-rate cuts from the Federal Reserve.
As a result, risk-reward for emerging market carry trades in a basket of currencies tracked by Bloomberg has slumped to the lowest since 2022.
“Higher yielders are going to be less attractive on a volatility-adjusted basis,” said Philip McNicholas, Asia-sovereign strategist at Robeco Singapore. “And with Trump now making volatility great again, the carry trade is liable to be a place where even angels fear to tread.”
Carry trades have served as a surefire way for emerging market investors to increase returns, but this strategy is fraught with risks during times of volatility. Mexico and China’s currencies have come under increased pressure as Trump threatened to impose 25% and 10% tariffs, respectively on their goods starting next month.
The lack of moves during Trump’s first days in office helped ease some of the tension. An index of developing currencies jumped last week as the US president failed to announce specific tariffs, adding to gains after he said he’d prefer not to use tariffs against the world’s second-largest economy.
The gauge retreated Monday as tariffs on Colombia came under the spotlight. Trump threatened punitive measures against the South American nation after its president refused to allow two US deportation flights to land. The White House later said it will hold off on the tariffs.
“With Trump in office and further clarification on his tariff agendas yet to be seen, carry trade will continue to be difficult, and we expect market volatility to increase in general,” said Valentina Chen, co-head of emerging market debt at Mackay Shields.
The yuan, Mexican peso as well as Asian and Central European currencies may “experience a relief rally if the eventual tariffs turn out to be not as aggressive as expected, but equally they can experience further downturn if these tariff negotiations turn out to be unproductive,” she said.
The pressure to unwind carry trades is not new, but it has intensified in the current backdrop of heightened market volatility.
The Bank of Japan’s surprise rate hike in late July fueled a firesale in everything that was funded in the yen offshore, including the Indonesian rupiah to Nvidia Corp. shares. In the prior month, traders were dumping the Mexican peso after a surprise election result in the country.
A basket of yen-funded trades handed returns of 12% last year, the worst since 2021, according to data compiled by Bloomberg. T. Rowe Price expects BOJ rates to top out at 1% and strengthen the yen, a move that would further dent carry trades in the currency. The central bank lifted the overnight call rate to 0.5% on Friday, the highest level since 2008, in line with market expectations
“I would give a little more pause for the EM yen-funded carry trades, as the trajectory for monetary policy between Japan and the US is in opposite directions,” said Leonard Kwan, a portfolio manager at T. Rowe. “Despite the lower funding costs now for the yen, the potential for yen appreciation as the spread between US and Japan rates narrow may eat into returns of the yen-funded carry trade.”
Relative Value
Some investors are still looking at relative performance in emerging markets to derive returns.
Goldman Sachs Group Inc. favors high-yielding Latin American currencies over their Asian peers. The Brazilian real and Mexican peso have already priced their fiscal issues and may rebound, whereas Asian currencies are susceptible to more yuan weakness, the bank’s strategists led by Andrew Tilton wrote in a note to clients.
Pictet suggests taking a cautious approach. Brazil’s assets are susceptible to further central bank rate hikes to counter the nation’s fiscal woes, said Sabrina Jacobs, a senior client portfolio manager in London. She suggests waiting for clarity on US tariffs before buying the Mexican peso.
Jacobs favors Turkey and South Africa on slowing inflation as well as Egypt and Nigeria on an improving macroeconomic outlook, using Asian currencies like the Thai baht and the Chinese yuan for funding.
“You have a lot of places which have very high real rates now and also room for the central banks to cut, particular still in Latam, but it doesn’t necessarily mean that you should buy all of them,” she said. “Pure carry doesn’t really work at the moment. You have to differentiate.”
What to Watch
China’s manufacturing PMI and Singapore’s unemployment rate data are due Monday
The Philippines, Saudi Arabia, Hungary and Mexico will announce their GDP data on Thursday, while Czech Republic releases its report the following day
Mexico will announce trade data on Monday, followed by Colombia on Thursday. Thailand, South Africa and Turkey will release the report on Friday
The central bank in Hungary will announce its policy decision on Tuesday. Monetary authorities in Brazil, Chile and South Africa are also due to release their rate decisions this week
--With assistance from Masaki Kondo and Marcus Wong.
(Updates with Colombia tariffs in eighth paragraph)
