What happened to carry trades
Dollar-funded carry - borrowing in the greenback to capture higher yields in developing markets - finally stumbled. A Bloomberg gauge shows the strategy turned negative for July through September after six consecutive quarters of gains, its first quarterly decline in two years. The damage was concentrated in September, when the approach lost money as the strategy posted losses across 16 of the 20 most-used EM currencies.
For the pros staying in, the hinge is the dollar, not every tick in Treasuries. The core wager works best when the greenback is steady, and many doubt that the greenback's latest uptick will persist.
Why the setback occurred
Yes, returns on Treasuries have climbed to levels not seen since 2007, and 10-year yields topping 5% grabbed headlines. But several managers argue the sudden jump in yields did the real harm, not the level itself. Over the period ending Sept. 28 that spanned five weeks, average Treasury yields rose by 66 basis points, and Bloomberg's dollar index advanced 2% yet remained under this year's highs. As Generali Asset Management strategist Guillaume Tresca said, "What matters the most is the USD."
Earlier this year, carry held up during a Treasury slide because the dollar did not strengthen, a move driven by worries over US government spending rather than policy. September was different. Rising rate expectations pushed yields higher and lifted the dollar, making the rout tougher for carry.
Carry trades work until they suddenly do not, and the unwind is always fast. Market Briefs covers currency and rate risk free every morning.
How managers are positioning now
Big EM players are not walking away. William Blair portfolio manager Yvette Babb put it plainly: "High US yields are not necessarily fatal for EM carry." With volatility up, she is getting choosier, prioritizing countries with credible policymaking, high yields and strong balance-of-payments positions. "The next phase of the carry trade is likely to be narrower and more idiosyncratic than the broad-based carry rallies seen in some previous cycles," she added.
At Ninety One, portfolio manager Thys Louw argues that bond markets are adjusting because energy is more expensive, hyperscalers' capital spending is propping up worldwide growth, and richer countries are issuing more debt. He doubts yields will keep rising at last month's clip. "We are likely closer to the end rather than the beginning of this repricing," Louw said. "Thus expectation is that we are close to peak volatility."
Nick Rees, head of Macro Research at Monex Europe Ltd., highlighted the shifting calculus: "The risk-reward calculation has changed." Treasuries look increasingly compelling on yield and as a potential buffer if the rapid rise in yields ends up breaking something in markets. Even so, many investors still do not see a sustained dollar rally. Tresca's take: if rates stay high but the dollar is calm, carry can keep working.
What could trip it up next
There are real risks. The Federal Reserve appears poised to raise interest rates. Treasury returns are at their highest since 2007.
The premium investors earn to compensate for emerging-market risk has nearly disappeared. The dollar is at three-month highs, buoyed by worries about a crisis in France, yet the move remains modest relative to earlier episodes of Treasury-market upheaval. On the supportive side, concerns about US fiscal credibility and a desire to diversify away from dollar assets may still underpin carry.
Bottom line for your money: the one-size-fits-all carry party is giving way to a pick-your-spots phase. Keep an eye on the dollar.
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