Collapsing Volatility Turbocharges Returns in Carry Trades

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Locascio also said Colombia’s peso has gained “significant traction” in carry strategies in recent weeks despite the currency’s higher volatility and less-liquid status.

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The peso is among the currencies that have benefited as costlier oil is expected to buoy energy-producing economies at the expense of countries that depend on imported fuel. And while crude prices are down from their wartime peak, they’re still well above levels before the conflict erupted, keeping that dynamic intact.

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“Emerging-market currencies of energy exporters outside the Middle East, particularly those currencies that have elevated real yields, can continue to outperform,” said Valerie Ho, a portfolio manager at DoubleLine. “Brazil’s real has emerged as a market favorite.”

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Fragile Situation

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Of course, the volatility backdrop can change in an instant given the fragile nature of the situation in the Middle East. US stocks fell on Thursday and oil rose as tensions picked up with peace talks stalled. 

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For Jamie Patton at TCW Group, it all points to investors being too complacent.

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“People are loading up the boats with risk in shallow water,” said Patton, TCW’s co-head of global rates. “However and wherever you look at risk being priced, it’s just too low.”

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Another concern is that the popularity of the strategy only increases the peril for both traders and the economies they pour cash into. 

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Crowded wagers on emerging markets — and, on the other side, short bets against currencies like the yen — can spark a rush for the exits depending on global events or changing macroeconomic expectations. A prime example was August 2024, when a policy shift by the Bank of Japan helped upend carry trades, triggering a yen rally and jolting global markets.

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An International Monetary Fund report this month flagged the rising sensitivity of hedge-fund performance to emerging-market carry returns in recent years. That suggests the unwinding of these trades, typically considered the territory of hot money that can flee quickly in times of stress, could put pressure on developing nations.

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Risk Adjustment

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For now, though, investors appear to be banking on the peace initiative to prevail. In currencies, a JPMorgan measure of volatility has tumbled from a multi-month high reached at the end of March, and is now around its lowest level since January. 

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That reversal is a boon for the carry trade because investors using the strategy rely on picking up small bits of yield over time, returns that can be swiftly wiped out by swings in exchange rates. So the calmer markets are, the better the approach looks on a risk-adjusted basis.

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“Markets always look through to the other end, and the carry trade is an opportunity to make money in a risk-on environment,” said George Boubouras, head of research at hedge fund K2 Asset Management. “But we may see some reversals in the next 30 to 90 days, potentially because it’s run so well.”

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—With assistance from Masaki Kondo, David Finnerty and Matthew Burgess.

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(Updates with Locascio comment in 9th paragraph.)

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