The emerging-market carry trade has demonstrated a notable rebound, recovering from initial losses incurred during the Middle East conflict. This resurgence is primarily driven by surging crude oil prices, which are reinforcing expectations for sustained elevated interest rates and bolstering the currencies of key commodity-exporting nations, with the Brazilian real and South African rand emerging as particular favorites among investors.
Carry Trade Index Shows Robust Recovery
An index designed to track this specific trading strategy has registered a significant upward movement, climbing more than 3% from its low point in March. Since the onset of the conflict in late February, the gauge has advanced approximately 1.7%. This index approximates the carry trade by measuring returns derived from borrowing in three low-yielding currencies—specifically the Japanese yen, Swiss franc, and Chinese yuan—and subsequently investing in eight higher-yielding emerging market currencies, which prominently include the Brazilian real and the South African rand.
Initially, the rally in oil prices, spurred by the Middle East conflict, presented a dual challenge for emerging markets. It first triggered a flight to safety, leading investors away from the sector. However, the past month has witnessed a reversal, with investors increasingly returning to growth-oriented assets. The sustained rise in crude prices has also intensified market expectations that central banks will be compelled to tighten monetary policy more aggressively to control consumer price inflation. This scenario is expected to ensure that real rates—nominal interest rates adjusted for inflation—remain attractive, thereby supporting the carry trade.
Jason Devito, a senior portfolio manager for emerging market debt at Federated Hermes Inc. in Pittsburgh, commented on the dynamics at play. “The EM carry trade will be buoyed by higher-for-longer real rates to combat incipient inflationary expectations,” Devito stated. He further elaborated on the varying impacts of oil prices within the sector: “While there are winners and losers within EM from higher oil prices, the losers are better prepared than ever, while the winners, such as Brazil for example, are supported by central bank credibility amid a backdrop of high real rates.”
Elevated Rates and Subdued Volatility Fuel Returns
Traders have been actively increasing their positions, betting that persistently high oil prices will maintain elevated inflation and policy rates across developing nations. Data compiled by Bloomberg indicates a clear trend: the average of 12-month interest-rate swaps from 14 emerging-market economies has risen to 5.7%, up from 5% before the Iran conflict began, reflecting these heightened expectations.
Beyond the interest rate differentials, the rebound in the carry trade has also benefited significantly from a period of relatively subdued currency volatility. A gauge of one-month emerging-market foreign-exchange volatility, tracked by a JPMorgan Chase & Co. index, currently stands at 6.88%. This represents a notable decrease from a high of 9.23% observed in the middle of March. Lower volatility is a critical factor supporting the carry trade, as it minimizes the risk that adverse exchange-rate fluctuations could erode or even negate the profits generated from interest-rate differentials.
Individual carry trade strategies have yielded impressive returns in this environment. For instance, a strategy involving borrowing in the Swiss franc and investing in the Brazilian real has delivered a return of 6.6% since the end of February. Similarly, funding in the Japanese yen and purchasing the Turkish lira has generated a gain of 6.9% over the same period, according to data compiled by Bloomberg.
Looking ahead, the current market environment appears to remain favorable for the emerging-market carry trade. Homin Lee, a strategist at Lombard Odier in Singapore, suggests that this is partly due to the expectation that the Federal Reserve will refrain from adopting a more hawkish stance under Kevin Warsh. Lee expressed a strong preference for specific currencies: “We are bullish on the Brazilian real first and foremost.” He emphasized Brazil’s robust position, noting, “Brazil is strongly positioned to withstand the ongoing energy market disruption and also benefit from the post-conflict global capex boom.”
The confluence of sustained high oil prices, expectations of elevated real interest rates, and reduced currency volatility has created a fertile ground for the emerging-market carry trade. As global economic dynamics continue to unfold, the resilience and attractive returns offered by this strategy, particularly in commodity-exporting nations like Brazil, position it as a compelling avenue for investors seeking yield in the current market landscape.
