It has been a good year for carry trades. Low FX market volatility – MUFG’s G10 FX implied volatility index is at its lowest level since January 2022 – is one positive factor. Others are stubbornly high inflation in the UK that is preventing the Bank of England from cutting borrowing costs, and the recent weakness of popular carry trade currencies such as the yen and Swiss franc.
Although markets are pricing in three rate cuts in the US this year, and at least one by the Bank of Japan – which would wipe about 100 basis points off the carry – the strategy will remain profitable for 2024, according to Russell Shor, senior market specialist at Tradu.
Simon Harvey, head of FX analysis at Monex, is more circumspect, noting that the carry trade has only been profitable on a select number of expressions this year. He notes that aggregate indicators – such as long emerging market local bonds indices and long emerging market high yield baskets – have actually produced negative returns so far this year once swings in the underlying currencies are accounted for.
“We think the carry trade has a limited shelf life this year,” he says. “The continuation of the emerging market easing cycle, alongside the commencement of the developed market easing cycle, should see markets emphasise valuations and support a lot of the low-yielding Asian currencies.
“We also think the options market is under-pricing the amount of risk on the horizon. Late-cycle vulnerabilities, geopolitical risk, and overall uncertainty over easing cycles should see both realised and implied volatility increase in FX markets – neither of which are conducive to carry trades.”
Cracks showing
Borrowing in yen and parking it in the Mexican peso has yielded more than 8% so far in 2024, but markets starting to price in a greater-than-even chance for a Bank of Japan rate hike in March could upend this popular trade.
“Cracks are starting to show in this popular but risky theme,” says Alexey Efimov, market analyst at Alpari. “Bloomberg’s EM-8 carry trade index, which measures the cumulative total return of a buy-and-hold carry trade position that is long eight BRL, IDR, INR, HUF, MXP, PLN, TRY and ZAR, is already down 0.6% so far this year.
“The relative stability of the Indian rupee could still prove popular as long as it adheres to its recent trading range.”
The Swiss National Bank’s lean towards an early rate cut, with inflation well under 2% and the economy flirting with recession, makes the Swiss franc a more attractive funding alternative
Ben Laidler, eToro
Given the dollar’s strength and high level of yield, Harvey does not believe it makes for a good funder. “Even lower yielding currencies like the yen don’t make for the best funders, primarily because of the risk of sudden appreciation should the Bank of Japan begin to normalise policy.
“In our eyes, only the Swiss franc scans as a reasonable G10 funding currency given its low yield and the SNB’s preference to contain further appreciation.”
Ben Laidler, global markets strategist at eToro, agrees that the yen is becoming riskier as the outlier Bank of Japan inches toward its first policy rate hike since 2007, potentially bolstering the world’s cheapest major currency.
“The Swiss National Bank’s lean towards an early rate cut, with inflation well under 2% and the economy flirting with recession, makes the Swiss franc a more attractive funding alternative,” he says.
In terms of receivers, the Indian rupee and the Mexican peso stand out for different reasons. Despite the rupee’s relatively lower yield, the Reserve Bank of India’s heavy management of the currency means the yield profile is much more attractive on a volatility-adjusted basis.
“By comparison, it is all about the level of carry in MXN,” says Harvey. “The peso’s 12-month implied yield stands at 10%, and there seems little downside risk of rate cuts in the near term given lingering upside inflation risks.
“A case can also be made for long Turkish lira exposure given the elevated level of yield, but this trade isn’t for the faint-hearted.”
Uncertainties
Kate Leaman, chief market analyst at AvaTrade, adds the Brazilian real, Russian ruble and South African rand to the list of currencies catching traders’ attention, while David Morrison, senior market analyst at Trade Nation, highlights countries with exciting growth prospects in southeast Asia, as well as others across South America.
“Brazil and Columbia have double-digit rates and at the extreme end of the scale there is Argentina and Zimbabwe, although the latter two are seen as far too risky to invest in with any safety,” he says. “The economic outlook for Vietnam looks promising, as it does in many emerging markets, and this goes in their favour as carry trade currencies. But they lack the liquidity that the currencies of bigger economies enjoy.”
Emerging or less developed markets, which often have less heavily traded currencies, can be subject to political instability or economic uncertainties that can suddenly alter the investment landscape
Matthew Weller, Forex.com and City Index
Ample liquidity on a range of instruments is crucial – mostly on FX swaps, adds Przemysław Kwiecień, chief economist at XTB.
Traders looking further out on the risk curve should be aware of the increased risk of large, rapid price movements that can erase gains from interest rate differentials.
“Emerging or less developed markets, which often have less heavily traded currencies, can be subject to political instability or economic uncertainties that can suddenly alter the investment landscape,” says Matthew Weller, global head of research at Forex.com and City Index.
“In addition, the costs associated with trading less heavily traded currencies – including spreads and fees – can be higher.”
There is a risk that even attractive yields get wiped out in a sudden stop scenario for less liquid currencies and those with saturated long positioning.
“Price impacts of trades are much more pronounced for less heavily traded currencies, leading to bulls having to pay higher prices as they try to long positions and bears chasing lower ones as they try to short positions,” explains José Torres, senior economist at Interactive Brokers.
