Introduction to the Carry Trade
The carry trade is a popular investment strategy that involves borrowing money in a low-interest rate environment and investing it in a higher-interest rate environment. This strategy is gaining popularity among emerging-market investors, driven by expectations that the Federal Reserve will cut interest rates next month. A weaker dollar and lower market volatility are also contributing to the appeal of the carry trade.
How the Carry Trade Works
Major money managers, such as Neuberger Berman Group LLC and Aberdeen Group Plc, are increasing their exposure to currencies from Brazil, South Africa, and Egypt. These investors borrow money in low-yielding currencies, such as the US dollar, and invest it in higher-yielding currencies. The goal is to earn a higher return on investment by taking advantage of the difference in interest rates between the two currencies.
Current Market Trends
After delivering double-digit gains earlier this year, the carry trade paused in July as the dollar briefly strengthened. However, momentum has returned following a weaker-than-expected US jobs report, which has spurred speculation that the Fed will cut rates to stave off recession risks. Many firms, including DoubleLine and UBS, have joined the growing list of bearish voices on the dollar, saying that the negative outlook for the greenback is "back in play."
Favorite Emerging Markets
According to Gorky Urquieta, co-head of emerging-market debt at Neuberger Berman, the risk of a major dollar resurgence is limited, and global growth still looks relatively stable. He favors positions in South Africa, Turkey, Brazil, Colombia, Indonesia, and South Korea. Donald Trump’s unpredictable trade and tariff policies have also pushed investors to diversify away from US holdings, contributing to the US Dollar Index’s weakest first-half performance since the 1970s.
Emerging Markets on the Rise
After a decade of US market dominance, capital is once again flowing into emerging-market assets, following three years of outflows. Global funds specializing in developing-world debt have enjoyed inflows every week for the past four months, drawing $1.7 billion in the week ending August 6, according to Bank of America data. An index tracking local-currency bonds in emerging markets has returned more than 12% this year, with 18 of 23 major EM currencies strengthening against the dollar.
Central Banks’ Role
Hawkish stances from several emerging-market central banks are adding fuel to the carry trade’s appeal. In recent weeks, Colombia surprised markets by keeping rates steady at 9.25%, India opted to hold rates, and Brazil pledged caution after being hit with a 50% US trade tariff. These moves have encouraged investors to seek higher returns in high-yielding currencies.
Carry Trade Performance
Leveraged funds have boosted bullish bets on the Mexican peso to their highest level in nearly a year, Commodity Futures Trading Commission data show. The move followed Mexico’s central bank decision to slow the pace of rate cuts. Lower global volatility has left low-yielding Asian currencies struggling, with data showing Asian FX carries an average return of negative 1.1%. By contrast, Latin American currencies average a positive 3.7% carry, while European and African currencies average 1.1%.
Conclusion
The carry trade is making a strong comeback among emerging-market investors, driven by expectations of a weaker dollar and lower market volatility. While some investors are trimming risk to secure profits, many strategists believe the carry trade rally has room to run. With the Fed expected to cut interest rates next month, the carry trade is likely to remain a popular investment strategy for those seeking higher returns in emerging markets. As Urquieta said, "If you’re comfortable with the FX outlook, not necessarily betting on a continued rally, but confident we won’t see a sharp dollar rebound — then these trades still look very attractive."
