Commerzbank’s Thu Lan Nguyen discusses the renewed popularity of FX carry trades as hopes grow for an end to the Middle East war. She stresses that long-run returns are not driven by interest differentials alone and warns that theory argues against persistent excess returns. Recent gains in G10 and EM carry baskets mask divergent outcomes between JPY and CHF funding strategies.

Carry appeal versus long term limits

"While an agreement between the US and Iran is still pending, investors are becoming increasingly bold on the back of hopes for an imminent end to the war in the Middle East. In the FX market, this can be seen in the fact that a comeback of so-called carry trades is already being proclaimed."

"Strategy is not primarily based on the interest rate differential, but on the expectation that the higher-yielding currency will appreciate against the lower-yielding currency. Why? Because exchange rates are generally far more volatile than interest rates, meaning that any exchange-rate movement will significantly outweigh the interest income."

"And indeed, this strategy has recently proven to be highly profitable. A strategy that, for example, goes long the three highest-yielding G10 currencies against the three lowest-yielding G10 currencies has delivered clearly positive returns since April of last year. An even better performance was achieved by a strategy that invested in selected emerging-market currencies."

"Of course, theory does not always match practice. The recent winning streak does not have to end overnight just because theory says so. In the 2000s there was even a very long period during which carry trades were extremely profitable."

"This shows that it pays to look at fundamental arguments for an appreciation or depreciation and not to blindly chase a trend."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor.)