The emerging-market carry trade has bounced back following initial losses from geopolitical events, with an index tracking this strategy up about 2.6% from its March low and 1.2% since late February. This rebound is attributed to rising crude oil prices bolstering commodity-exporting currencies and reinforcing expectations of sustained elevated interest rates. The strategy involves borrowing in low-yielding currencies like the Japanese yen, Swiss franc, and Chinese yuan, and investing in higher-yielding emerging market currencies such as the Brazilian real and South African rand.
Latin American currencies are demonstrating notable resilience, defying the impact of Federal Reserve interest rate adjustments. Despite a general reduction in holdings of high-yielding emerging market currencies, Latin America stands out as the only region where no currencies are considered "underheld" by BNY's iFlow data. This suggests that while the carry trade has become more selective and challenging, its fundamental appeal in the region remains intact. Brazil and Chile are particularly cited as strong examples benefitting from positive terms-of-trade shocks, with export values reaching multi-year highs which helps to counteract a stronger dollar.
However, the Federal Reserve's tighter monetary policy has raised the bar for all carry trades, requiring higher compensation for currency risk. This new reality pressures local central banks to be more cautious with rate decisions, even in countries like Brazil where the benchmark Selic rate was at a high 14.25% before the conflict. Despite these pressures and some bond outflows, Latin American fixed income holdings have only declined marginally (less than 2 percentage points), remaining about 14% above their rolling 12-month average. The stability of emerging market currencies, particularly compared to G-7 nations, further supports the carry trade, with a JPMorgan volatility index showing developing nations' currencies have been less volatile for nearly 200 consecutive days.
Geopolitical anxieties, such as those related to Iran, have intermittently created "risk-off" scenarios, pushing investors towards safer assets like the US dollar and Treasury yields. During such events, Latin American currencies and stocks, including Brazil's real and Chile's peso, have faced pressure. For instance, the 30-year Treasury yield topped 5% for the first time since 2007 during one such period. These episodes highlight that while high local interest rates offer some protection, they are not always sufficient to completely shield against global risk aversion. Chile, for example, even increased its countercyclical capital buffer to 1.0% of risk-weighted assets from 0.5% during a period of market tension to further strengthen its financial system.
