Capital Ideas^TM

The EM carry trade¹ has been a successful strategy so far this year, as many EM countries, particularly those in Latin America, have been able to offer investors high real interest rates, diminishing policy risks and attractive valuations.

Chart 1: High carry currencies have been strong year-to-date

Past results are not a guarantee of future results.

As at 11 September 2023. KRW: South Korean won, MYR: Malaysian ringgit, SGD: Singapore dollar, THB: Thai baht, TWD: Taiwan dollar, BRL: Brazilian real, MXN: Mexican peso, IDR: Indonesian rupiah, EUR: Euro, GBP: Pound sterling, JPY: Japanese yen, CAD: Canadian dollar, COP: Colombian peso, NOK: Norwegian krone, RUB: Russian rouble. Source: Macrobond

The strength of the EM carry trade now looks to be fading as EM central banks start to cut rates. This reduction in interest rate differentials between EM and developed market (DM) countries could weaken some EM currencies, as was the case in Chile earlier this year. Crowded investor positioning within EM carry trades, meanwhile, has the potential to amplify any reversal in positioning.

That said, given the high starting interest rate for many EM countries, real rates may continue to look attractive even as central banks cut rates. Moreover, in many cases, investors are guided by risk sentiment and fundamentals as well as the real rate differential. We look into both those factors in this paper.

1. An exchange rate “carry trade” goes against the uncovered interest rate parity theory (UIP). According to UIP, the expected change in an exchange rate should be equal to the interest rate differential for the two currencies for the same period. If this does not happen, in theory, there is an opportunity to make an abnormal return, using the carry trade, by borrowing a low interest-rate currency and investing in a higher interest rate currency.