Macro

Carry Trade Gains Momentum in Global Bond and FX Markets, Led by Chilean Peso

Carry trades surge with nearly 7% YTD returns, driven by Fed's no-hike signal and low volatility.

By Max Weldon

5/25, 02:20 EDT
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Key Takeaway

  • Wall Street strategists are favoring carry trades, leveraging high-yielding currencies and bonds amid subdued market volatility.
  • UBS recommends selling Swiss francs to buy US and Australian dollars; Societe Generale favors riskier European government bonds.
  • Emerging markets see a resurgence in carry trades, with the Chilean peso and Mexican peso leading gains.

Carry Trades Gain Momentum

Exploiting differences in interest rates, known as carry trades, is set to become a dominant investment strategy in the coming months. Wall Street strategists are increasingly recommending this approach, which involves borrowing in low-yielding currencies to invest in higher-yielding ones, capitalizing on the income differential. This strategy thrives in low-volatility environments, where the risk of significant price swings is minimized.

UBS Group AG suggests selling the Swiss franc to buy US and Australian dollars, while Societe Generale SA favors riskier European government bonds. Pictet Asset Management is locking in high yields with local-currency bonds from Mexico and Brazil. The Federal Reserve's recent signaling of no further rate hikes has removed a potential volatility trigger, setting the stage for cautious easing alongside major peers like the European Central Bank and Bank of England. "The Fed’s signaling of no further hikes is a green light for carry trades in fixed income and elsewhere," wrote Bank of America strategists, including Ralph Axel. They noted that subdued volatility "should support a wide range of carry trades over the summer."

Strong Performance in Developed Markets

The carry trade has already shown strong performance in developed currency markets this year. A Bloomberg index tracking the strategy of selling the lowest-yielding G10 currencies to buy the highest yielders has returned nearly 7% year-to-date, marking the best performance by this point in the year since 2009. This trend is expected to continue as inflation remains sticky and resurgent growth limits the extent of policy easing by central banks, thereby keeping market volatility in check.

UBS strategists, including Shahab Jalinoos, recommend using the Swiss franc as a funding currency to buy US and Australian dollars. They argue that the franc is uniquely at risk due to the prospect of larger rate cuts than the market is currently pricing. In contrast, the Australian dollar appears appealing due to sticky inflation and an upcoming fiscal boost, which raises the odds of sustained rate support. The Commodity Futures Trading Commission (CFTC) data on Friday will be closely watched for signs that investors are shorting certain currencies to fund their carry trades or increasing long positions in higher-yielding currencies.

Emerging Markets and High-Yield Bonds

In emerging markets, the carry trade strategy is making a significant comeback. A gauge of interest-rate arbitrage in developing-nation currencies is poised for the biggest monthly gain since November, with 20 of the 21 most widely used emerging market currencies producing positive returns in May. The Chilean peso is leading the pack, rallying on higher copper prices, while the Turkish lira and the Mexican peso are also contributing due to interest-rate hikes and cautious central bank policies, respectively.

Andres Sanchez Balcazar, head of global bonds at Pictet Asset Management, is buying local-currency bonds in Mexico and Brazil to ensure returns on his portfolios beat cash. He is also investing in ultra short-dated, dollar-denominated debt from African countries, including Angola, Ghana, and Zambia. "Curves are inverted, spreads are tight, so this is probably not the time to take a lot of risk," he said. "If anything, this is the time to make sure that you have enough carry in your portfolio to beat the cash rate."

Street Views

  • Ralph Axel, Bank of America (Bullish on carry trades in fixed income):

    "The Fed’s signaling of no further hikes is a green light for carry trades in fixed income and elsewhere. Subdued volatility should support a wide range of carry trades over the summer."

  • Shahab Jalinoos, UBS (Bullish on US and Australian dollars against Swiss franc):

    "The case to use the franc as the funding currency is boosted by the prospect of larger rate cuts than the market is pricing, putting it uniquely at risk. In contrast, the Aussie dollar looks appealing given sticky inflation and an upcoming fiscal boost, raising the odds that it gets sustained rate support."

  • Peter Schaffrik, RBC Capital Markets (Neutral on general market conditions but bullish on carry trades):

    "Carry trades are being put on everywhere as investors prepare for this quiet period."

  • Andres Sanchez Balcazar, Pictet Asset Management (Bullish on local-currency bonds from Mexico and Brazil):

    "Curves are inverted, spreads are tight, so this is probably not the time to take a lot of risk. If anything, this is the time to make sure that you have enough carry in your portfolio to beat the cash rate."