By Harry Robertson
LONDON (Reuters) – A sharp fall in the Mexican currency after a landslide election result rattled foreign exchange markets as far as Hungary and Turkey this week, leaving investors wondering whether the unwinding of the popular “carry trade” will continue.
A carry trade involves investors borrowing in currencies with low interest rates, such as the Japanese yen or Swiss franc, and buying higher-yielding currencies such as the Mexican peso, or more recently the US dollar. Its popularity has boomed as interest rates vary around the world and market volatility remains low.
However, the peso's dramatic decline against the yen this week – falling 4.4% on Monday in its biggest daily decline since the Covid-19 crisis – is a sign that investors are quickly pulling back from some of their favorite and most profitable trades. .
Pockets of volatility remained on Wednesday, with the yen falling sharply against the dollar, leaving investors pondering whether the old approach is still viable.
“The general rise in exchange rate volatility in emerging markets… has led to deleveraging across the world,” said Chris Turner, head of global markets at ING. “Where do we go from here?”
Electoral shocks
News that Claudia Sheinbaum has won a landslide in Mexico's presidential election has caused the value of the peso to fall, with markets spooked by potential constitutional reforms and their impact on US-US trade relations.
The Indian rupee also tumbled on Tuesday after it became clear that business-friendly Prime Minister Narendra Modi would lose his majority.
The double decline caused sharp volatility in emerging markets, hurting other favored currencies such as the Hungarian forint and the Turkish lira. Low-yielding “finance currencies” such as the yen and peso rose, while the euro and dollar bounced in waves.
Volatility is a big threat to carry trades. A rise in the currency in which investors borrow, or a fall in the currency in which they invest, can wipe out gains from yield spreads.
“My feeling is that participants have largely liquidated these trades and moved to stabilization,” said Neil Jones, a senior executive for FX sales at TJM Europe. “The market is likely still holding core long-term carry trades, but certainly much less than the previous 48 hours.”
Yet some spy an opportunity. Chris Weston, head of research at Pepperstone, said: “With the peso-yen exchange rate falling 6.3% in two days, we question whether the shakeout has largely occurred and whether this is the right time to re-engage.” “This trade looks aggressive, but let's see how Japanese traders play the yen's movements today.”
Moving parts
Investors will have to measure a whole host of factors when deciding whether to return to carry trading strategies. ING's Turner said markets will closely monitor Sheinbaum's policies and the path of the US dollar, the main driver of global currencies.
“In Mexico, it appears that local authorities are already trying to calm investors about potential financial concerns,” he said. “Internationally, we believe the scope for slightly lower US interest rates and a weaker dollar could support the risk environment, reduce volatility and limit further carry trade selling.”
Also worrying is the possible path for the yen. Another factor pushing the Japanese currency higher this week is speculation that the Bank of Japan may raise interest rates in July, with officials warning that they are closely monitoring the yen's movements.
Intervention still poses a threat, after Japanese authorities spent $62 billion to support the currency about a month ago. The rise in the value of the Japanese yen, which reached a 34-year low this year, could create more problems for carry trades.