The expectation of a US dollar interest rate cut triggers arbitrage trading, with capital flowing into high-yield emerging market currencies

Against the backdrop of rising expectations for interest rate cuts by the Federal Reserve, a weakening dollar, and relatively high interest rates in emerging markets, carry trades are making a strong comeback, with a large influx of funds into emerging markets.

According to a report by Bank of America citing EPFR data, over the past four months, global funds specifically investing in bonds from developing countries have seen weekly inflows, with the week ending August 6 seeing a single-week inflow of as much as $1.7 billion.

So far this year, 18 out of 23 major emerging market currencies have appreciated against the dollar. Asset management companies such as Neuberger Berman and Aberdeen Group are repositioning in high-yield currencies like those of Brazil, South Africa, and Egypt, leading to the first sustained inflow of funds into emerging market assets in three years.

Currently, carry trades have achieved double-digit returns, with the Bloomberg cumulative foreign exchange carry trade index (which tracks the performance of eight emerging market currencies against the dollar) rising over 10% this year. However, several analysts believe that carry trades may have further upside potential. For instance, JPMorgan previously upgraded the ratings of emerging market currencies and local currency bonds to "overweight," citing the resumption of the weakening trend of the dollar after a month-long pause.

Weak Dollar Clears Obstacles for Carry Trades

Carry trading refers to investors borrowing low-interest currencies (such as the dollar, which may be cut in the future, making borrowing costs low) and converting them into high-interest currencies for investment (such as emerging market currencies like Brazil and Mexico, which can earn higher interest), thereby earning interest rate differential profits. Additionally, if the high-interest currency appreciates against the dollar, even more profits can be made.

Analysts state that the core reason for the renewed popularity of carry trades is that "the environment has become friendlier."

First, weak U.S. employment data has intensified market bets on a Fed rate cut in September, reducing the dollar's attractiveness and lowering future borrowing costs in dollars. Several institutions, including DoubleLine and UBS, have joined the ranks of dollar bears, stating that "the story of a weakening dollar is back."

Second, emerging market interest rates are high, creating a large interest rate differential. Many emerging market central banks are maintaining or even raising interest rates due to inflation concerns, such as Brazil's rate at 15%, Colombia maintaining 9.25%, Mexico slowing its rate cuts, and India choosing to hold steady. The significant interest rate differential between these high-interest currencies and the low-interest dollar attracts investors to buy.

Third, market volatility has decreased, lowering risk. Data shows that the gap between the expected volatility of emerging market currencies and that of G10 developed economies' currencies for the next month is close to a 12-year high, indicating reduced volatility in emerging markets and lower risks for carry trades. Stable market periods are more suitable for carry trades, as extreme fluctuations can erode interest rate differential profits.

Latin American Currencies Benefit Most

Carry trade returns for Latin American currencies are relatively good. Data shows that the carry yield for Latin American currencies is 3.7%, while that for Europe and Africa is 1.1%. In contrast, Asian low-interest currencies are relatively constrained, with the average carry yield for Asian currencies at -1.1%, indicating that holding costs exceed the potential returns of holding dollars. Taking the Brazilian real and the Mexican peso as examples. Kieran Curtis, head of local currency debt for emerging markets at Aberdeen, stated that going long on the Brazilian real is one of our favorite positions, mainly due to its high yield. According to the latest data from the Commodity Futures Trading Commission, as of the week ending August 5, leveraged funds' bullish bets on the Mexican peso have risen to the highest level in nearly a year. This period coincided with the Bank of Mexico's decision to slow down its monetary easing.

Gustavo Medeiros, head of research at Ashmore Group, mentioned that in a market environment with a risk-on sentiment, high-yield spread carry trades typically perform better. From this perspective, high-yield spread countries in Asia, such as Indonesia and India, will certainly perform well, but Latin America may benefit even more.

However, some investors are reducing risk bets to lock in profits, concerned that Trump's tariff policies could weigh on the economy and push up U.S. inflation. A large amount of data to be released in the coming days, including U.S. inflation data and Russia-Ukraine negotiations, could bring new turbulence to global markets