The unwinding of carry trades in emerging markets has escalated into a significant market disruption, affecting global financial landscapes. On Monday, the Japanese yen and Chinese yuan saw notable gains, while the Mexican peso continued its steep decline. The peso depreciated over 5% against the U.S. dollar, whereas the yen surged nearly 3% and the yuan increased approximately 0.7%.
This market turmoil comes amid a broader selloff in risk assets, which has hammered everything from equities to cryptocurrencies. The intensifying concerns over the Federal Reserve’s adequacy in supporting a slowing U.S. economy have driven investors toward safer assets like bonds.
The sharp rise in funding currencies has dealt a severe blow to the carry trade strategy. This strategy, which involves borrowing in currencies with low interest rates to invest in higher-yielding assets—often in emerging markets—has been particularly vulnerable in the current climate.
Alvin Tan, Head of Asian Currency Strategy at the Royal Bank of Canada in Singapore, attributes the turbulence to recession fears. “Recession risk also translates to increased market volatility, leading to the reduction of carry trades,” Tan explained. “Given that we’ve been in a prolonged period of low volatility, this shift could continue as the situation evolves.”
Carry trades funded by the yen, previously favored due to stable low interest rates in Japan, have been upended following the Bank of Japan’s recent rate hikes and signals of potential further increases. Similarly, traders who had relied on the yuan, anticipating its weakening due to concerns over China’s economic outlook, are facing challenges.
Data from Bloomberg reveals that returns from a basket of emerging market currencies funded by the yuan turned negative on Monday. Gains from yen-funded carry trades are also approaching a reversal.
Nick Twidale, Chief Markets Analyst at ATFX Global Markets, described the situation as a “massive capitulation of carry trade positions.” He noted that the initial trigger was the Bank of Japan’s rate hike, but global growth anxieties have exacerbated the volatility, intensifying market movements.
