Emerging Market Carry Trade Thrives Amid Dollar Weakness

[By Myungjeong Seon, Block Media] The carry trade in emerging markets is experiencing its longest streak of consecutive profits since 2008, fueled by a weak dollar and high interest rates in emerging economies. The strategy of borrowing funds in currencies with relatively low interest rates, such as the US dollar or Japanese yen, and investing in high-yield currencies like the Turkish lira, Brazilian real, and Colombian peso is gaining renewed attention.

According to Bloomberg, the carry trade based on dollar funding for eight major emerging market currencies has recorded positive returns for seven consecutive quarters. Cumulative returns are expected to reach approximately 22% by the end of 2024, significantly surpassing the 5.9% yield on US Treasury bonds during the same period. Dollar bonds issued by emerging market governments have yielded 14%, while corporate bonds have yielded 10%.

Market analysts suggest that the US Treasury's expansion of long-term bond buybacks and expectations for stability in long-term US interest rates could reduce the relative attractiveness of dollar assets, providing additional momentum for emerging market carry trades.

"The World of Carry"... Dollar Weakness Boosts Yields

On the 23rd (local time), major foreign media outlets, including Bloomberg, reported that Kathy Hepworth, head of emerging market bonds at PGIM, responded with "Carry, carry, carry" when asked about the most confident investment theme in emerging markets.

The carry trade is a strategy that involves borrowing at low interest rates to invest in assets that offer higher interest rates, profiting from the interest rate differential. Recently, the US dollar and Japanese yen have been used as funding currencies, while the Turkish lira, Brazilian real, Colombian peso, Mexican peso, and South African rand have been identified as major investment currencies.

The recent performance has been bolstered by exchange rates. The dollar has weakened against major emerging market currencies outside of Asia, and it has also depreciated against other low-interest funding currencies like the euro and Swiss franc, expanding carry yields.

In Colombia, bond yields of about 12% combined with the appreciation of the peso against the dollar have led to a carry trade return of 48% over the past 12 months. Although the Turkish lira has depreciated by about 26% against the dollar during the same period, the yield on local currency bonds with a 10-year maturity has exceeded 32%, resulting in overall profits.

In the last 12 months, the carry trade returns based on dollar funding have been 48% for the Colombian peso, 23% for the Turkish lira, 21% for the Brazilian real, 19% for the Mexican peso, and 18% for the South African rand.

Hepworth stated, "There is a lot of money looking for yields," and expressed a preference for Turkey, Colombia, Brazil, and some frontier markets in Sub-Saharan Africa.

US Treasury Bond Buybacks Favor Emerging Markets

The recent policies of the US Treasury are also creating a favorable environment for carry trades.

Last week, the US Treasury announced an expansion of its long-term bond buyback program. The market interprets this move as a demonstration of the government's commitment to suppressing long-term interest rate increases.

If US long-term interest rates decrease, the relative attractiveness of dollar-denominated bonds may diminish. Conversely, emerging market assets that maintain high interest rates may appear more attractive in terms of interest rate differentials.

Daniel von Allen, head of macro strategy at TS Lombard, noted that the US administration seems to have a low tolerance for rising US Treasury rates, suggesting that this environment supports emerging market carry trades.

The MSCI Emerging Market Currency Index has also set multiple all-time highs this year. This index reflects interest income and has risen by 3.6% since the end of 2025 and by 11% since the end of 2024.

Alejo Cherwienko, Chief Investment Officer for UBS Global Wealth Management in the Americas, predicts that emerging market currencies will generate positive total returns over the next 12 months, emphasizing that the recent significant appreciation of spot exchange rates will make interest rate differentials a more important driving force going forward.

High Real Interest Rates are Key... Favorable Conditions in Latin America and Eastern Europe

The primary reason for the strength of carry trades is that central banks in emerging markets continue to maintain high interest rates.

In particular, countries in Latin America and Eastern Europe have kept benchmark interest rates high to curb inflation since the COVID-19 pandemic. Tensions in the Middle East and high energy prices are also factors that make it difficult for central banks to lower rates quickly.

As a result, countries with high real interest rates, adjusted for inflation, have created favorable conditions for carry trades.

Cherwienko expressed a preference for the South African rand and Mexican peso, suggesting strategies that utilize the euro and Canadian dollar as funding currencies.

Kamaksya Trivedi, a senior foreign exchange and emerging markets strategist at Goldman Sachs, predicts that inflation is sufficiently stable, making it unlikely for the Federal Reserve to raise rates in the near term.

Trivedi assessed that while rising long-term interest rates could pose a short-term threat, as long as the movements are not too rapid, emerging market currencies with high real interest rates can continue to generate positive total returns.

Too Good to be True?... Caution Against "Overcrowded Trades"

However, as carry trades have recorded high returns for an extended period, concerns about investor concentration are also growing.

Carry trades can yield high returns when interest rate differentials are large and exchange rate volatility is low, but if market sentiment shifts rapidly, losses can also escalate quickly. Particularly, if the funding currencies like the dollar or yen suddenly strengthen, investors may face currency losses.

The biggest risk is a change in the outlook for US interest rates. If US rates rise higher than expected or if the Federal Reserve turns hawkish again, the dollar may strengthen, potentially curtailing the upward momentum of emerging market currencies.

Recent US economic indicators and comments from Federal Reserve officials support the possibility that further rate hikes may be delayed until next year, but if long-term interest rates surge or inflation concerns resurface, the situation could change.

Ning Sun, a senior emerging markets strategist at State Street, assessed that current US economic indicators are not weak enough to reverse the risk appetite that has supported emerging market carry trades. He expressed a preference for the Colombian peso, South African rand, and Turkish lira.

Ultimately, the current emerging market carry trade is benefiting from three simultaneous conditions: expanding interest rate differentials, low exchange rate volatility, and a weak dollar. If US long-term interest rates stabilize and the dollar remains weak, the profitability of this strategy may continue.

Conversely, if US rates rise again or if the dollar experiences a sharp rebound, the recently overcrowded positions may unwind all at once, posing a risk factor. The continuation of the "world of carry" that has persisted for seven consecutive quarters ultimately depends on the direction of US interest rates and the dollar.