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Unwinding of Hugely Popular Currency Trade Rocks Markets

A sharp drop in Mexico’s currency following a landslide election result has caused significant disruption in foreign exchange markets, affecting currencies as far away as Hungary and Turkey. This has led investors to question the future of the widely favored “carry trades.”

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Carry trades involve borrowing in low-interest-rate currencies like the Japanese yen or Swiss franc and investing in higher-yielding ones such as the Mexican peso or the U.S. dollar. These trades have gained popularity due to the divergence in global interest rates and low market volatility.

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However, the peso’s significant drop against the yen this week—falling 4.4% on Monday, its biggest daily decline since the COVID-19 crisis—signals that investors are rapidly exiting some of their most profitable trades.

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Election Shocks and Market Volatility

The landslide victory of Claudia Sheinbaum in Mexico’s presidential election triggered the peso’s tumble, with concerns over potential constitutional reforms and the impact on U.S. trade relations. Similarly, India’s rupee also stumbled when it became apparent that Prime Minister Narendra Modi’s business-friendly government would lose its majority.

These developments caused wild swings across emerging markets, affecting favored currencies like Hungary’s forint and the Turkish lira. At the same time, low-yielding “funding currencies” such as the yen and peso rallied, and the euro and dollar experienced fluctuations.

Volatility poses a significant threat to carry trades. A rise in the currency used for borrowing or a drop in the currency in which investments are made can erase gains from yield differentials.

Investor Reactions and Opportunities

Chris Turner, head of global markets at ING, noted that the generalized rise in emerging market FX volatility has led to de-leveraging in carry trades worldwide. Neil Jones, a senior FX sales executive at TJM Europe, mentioned that many participants have largely liquidated these trades and moved to a flat position, though some core long-term carry trades likely remain.

Despite the turmoil, some investors see potential opportunities. Chris Weston, head of research at Pepperstone, suggested that after the peso-yen cross fell 6.3% in two days, there might be a chance to re-engage with the trade, albeit with caution.

Future Considerations for Carry Trades

Investors need to consider several factors when deciding whether to return to carry trade strategies. Key considerations include the policies of Mexico’s new leadership, the path of the U.S. dollar, and broader market conditions. Turner highlighted that calming measures by Mexican authorities and the potential for lower U.S. rates and a softer dollar could support the risk environment, reduce volatility, and limit further sell-offs in carry trades.

Additionally, the yen’s future trajectory is crucial. Speculation about the Bank of Japan potentially raising interest rates in July and the possibility of intervention to support the yen add layers of complexity. Japanese authorities have already spent $62 billion to prop up the yen around a month ago. A rally in the yen, which has languished at 34-year lows this year, could pose more challenges for carry trades.

Overall, the unwinding of carry trades in response to recent market shocks underscores the need for investors to stay vigilant and adaptable in a volatile global financial landscape.

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