The foreign-exchange (FX) carry trade has been a bright spot for investors this year, and although there are signs that some prominent strategies are under threat, there remain grounds for optimism. That’s particularly true of some Southeast Asian currencies and the Mexican peso
Boom time for the EM FX carry trade to continue?
Shooting for the stars
The carry trade – an investment strategy that tends to focus on foreign currencies and takes advantage of differences in borrowing costs between countries – has re-emerged as a very popular strategy this year. Indeed, it’s delivered bumper returns as most central banks have hiked rates, causing yields to rise, but at different paces.
As an example, investors might borrow Japanese yen – Japan’s central bank continues to follow an ultra-easy monetary policy, with interest rates at very low levels – and convert those yen into Mexican peso to buy much higher-yielding bonds. While one-year bond yields in Japan average negative 0.1%, their Mexican counterparts deliver a yield of around 11%.
That Japanese yen/Mexican peso strategy has been one of the most popular carry trades in 2023. Others that have delivered significant profits include those involving the Brazilian real, the Colombian peso, the Hungarian forint and the Indonesian rupiah. 1 Bloomberg’s FX carry trade index, which measures the carry-trade returns from eight emerging-market currencies, had risen by 4.8% by July 2023 – the highest level since 2017, according to FX Markets. 2
Best six months for the carry trade since 2017
Cause for concern?
There are some emerging threats to the carry trade, however. Global carry traders are particularly concerned that the turning of the monetary cycle could cause volatility in FX markets to spike. Bloomberg has quoted DBS strategist Chang Wei Liang as saying:
‘Carry trades, such as being long dollar-yen, are prone to be toppled over if commonly assumed policy trends unexpectedly reverse.’ 3
The probability that the interest-rate hiking cycle in the advanced economies is coming to an end as inflationary pressures subside could prove a key turning point. Meanwhile in Japan, inflation is finally tightening its grip on the economy amid growing speculation that the Bank of Japan may start to unwind its decades-long ultra-easy monetary stance. So, if the US starts to ease monetary policy – possibly next year – just as Japan starts to tighten, the gap between US and Japanese interest rates – which has weighed heavily on the yen – would close, ending the long USD/JPY strategy, one of the most prominent carry trades.
Emerging FX carry trade finds continued support
However, there are reasons to believe the strong performance of the carry trade in key emerging-market currencies can continue. Many benefit from strong reserves and a healthy balance of payments, as well as a prudent central bank. Growth in Asia also appears to be decoupling, outpacing the advanced economies by a significant degree. That trend will provide further support to the currencies of Indonesia and others.
HSBC, for example, has forecast that the six largest economies in Southeast Asia – Indonesia, Thailand, Malaysia, the Philippines, Singapore and Vietnam – will expand by 4.2% in 2023 and 4.8% in 2024, significantly outpacing an anticipated 1.1% and 0.7% expansion in the developed world in those same years. 4
Prospects for the Mexican peso carry also appear good, given the outlook of continued high interest rates and a strong currency in Mexico. With inflation well under control in Latin America in general, other currencies in the region may find continued support even as interest rates fall. This is particularly likely to be true if the rate-easing cycle coincides with a similar move in the US.
Perhaps the biggest threat to the carry trade in Latin America lies in a sharp Chinese slowdown. That would particularly affect Peru, Chile and Brazil, which export vast quantities of raw materials across the Pacific.
1 https://www.fx-markets.com/trading/7948893/hedge-funds-turn-to-exotics-for-em-carry-trades
2 https://www.fx-markets.com/trading/7948893/hedge-funds-turn-to-exotics-for-em-carry-trades
3 https://www.bloomberg.com/news/articles/2023-07-13/carry-traders-fret-that-good-times-may-be-closer-to-an-end
4 https://asia.nikkei.com/Opinion/Southeast-Asia-s-economic-outlook-is-only-brightening
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