Harry Robertson
LONDON (Reuters) – A sharp fall in Mexico’s currency following a landslide election result rocked currency markets as far away as Hungary and Turkey this week, leaving investors wondering whether the winding down of hugely popular carry trades will continue.
The carry trade involves investors borrowing in currencies with low interest rates, such as the Japanese yen or Swiss franc, and buying higher-yielding currencies such as the Mexican peso or, more recently, the US dollar. Its popularity has surged as interest rates across the world have diverged and market volatility has remained low.
However, the peso’s sharp fall against the yen this week (it fell 4.4% on Monday, its biggest one-day drop since the Covid-19 crisis) is a sign that investors are quickly abandoning some of their favorite and most profitable trades. .
Pockets of volatility persisted on Wednesday, with the yen falling sharply against the dollar, prompting investors to question whether the old approach is viable.
“The general increase in currency volatility in emerging markets… has led to deleveraging in trading around the world,” said Chris Turner, head of global markets at lender ING. “Where do we go from here?”
ELECTION SHOCKS
News that Claudia Sheinbaum would win the Mexican presidential election sent the peso tumbling, with markets spooked by possible constitutional reforms and their impact on trade relations with the United States.
The Indian rupee also fell on Tuesday as it became clear that business-friendly Prime Minister Narendra Modi would lose his majority.
The double decline caused wild swings in emerging markets, plunging other popular currencies such as the Hungarian forint and the Turkish lira. Low-yielding “funding currencies” such as the yen and peso rose while the euro and dollar faltered.
Volatility is a big threat to carry trades. A rise in the currency in which investors borrow, or a fall in the currency in which they invest, could wipe out the gains from the yield differential.
“I believe participants have largely liquidated these trades and moved into a neutral position,” said Neil Jones, senior manager of FX sales at TJM Europe. “The market is likely still supporting the underlying long-term carry trades, but is certainly significantly lower than 48 hours earlier.”
However, some are spying on the opportunity. “With the peso-yen exchange rate down 6.3% in two days, we are asking whether the shakeout is over and whether it’s time to reopen,” said Chris Weston, head of research at Pepperstone. “This trade seems aggressive, but let’s see how Japanese traders play out the yen’s move today.”
MOVING PARTS
Investors will have to evaluate a number of factors when deciding whether to return to carry trading strategies. ING’s Turner said markets would closely monitor Sheinbaum’s policies and the U.S. dollar, the main driver of global currencies.
“It appears that in Mexico local authorities are already trying to reassure investors about possible financial problems,” he said. “And internationally, we believe opportunities for slightly lower US rates and a softer dollar could support the risk environment, reduce volatility and limit further sell-off in the carry trade.”
Also of great concern is the likely trajectory of the yen. Another factor driving the Japanese currency higher this week was speculation that the Bank of Japan could raise interest rates in July, with officials warning they were keeping a close eye on the yen’s movements.
Intervention remains a threat after Japanese authorities spent $62 billion to prop up the currency about a month ago. The rally in the yen, which has stalled at 34-year lows this year, could create new problems for the carry trade.