Background
Emerging-market carry trades have been seeing elevated returns as of late due to lower volatility in the FX markets and favorable conditions against the U.S. dollar. Interest rates have remained elevated in key developing economies, allowing for higher profits in the carry trade
Borrowing the U.S. dollar and the yen to buy Brazilian real, Mexican peso and Hungarian forint has beaten the S&P 500’s year-to-date rally, with falling volatility fueling the specter of further gains.
The issue
The J.P. Morgan Global FX Volatility Index, which measures three-month implied volatility, recently declined to 8.86%, the first time the index has been below 9% since before Russia’s invasion of Ukraine in 2022.
“This is a sign of the times where interest rates are converging to or at the terminal levels,” said Simon Harvey, Head of FX Analysis at Monex Europe Ltd. “At high nominal levels and against a backdrop of cooling inflation conditions, the probability of larger-than-expected rate hikes or an upwards reassessment in terminal rates is dramatically lower. And this lower rates volatility is mapping into currency markets.”
Meanwhile, a strategy of buying one-month Hungarian forint forwards and selling dollars has yielded 17.5% year-to-date, excluding trading costs. That’s among the highest returns of common liquid strategies. Similar approaches using the Mexican peso and the Brazilian real have produced year-to-date returns of 17.2% and 14.3%, respectively.
The Mexican peso has reached its strongest level since 2017, with U.S. economic stability, nearshoring and remittances among the contributing factors. Across Latin America, countries raised interest rates earlier than the U.S. Federal Reserve and could soon take the lead in rate cuts, writes John Authers of Bloomberg Opinion.
Tracking
Use Bloomberg’s IN and FXFA tools to track the performance of currency pairs, and calculate implied costs. Run FXSW to backtest custom multi-currency strategies.
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