Weak dollar reprises its role as 'carry' trade funder

The weakening U.S. dollar under the Trump presidency has spurred a resurgence in dollar-funded carry trades, with investors borrowing dollars to invest in higher-yielding emerging market currencies like the Indonesian rupiah, Indian rupee, and Brazilian real. Fund managers at firms like Vontobel and M&G Investments are increasing carry trade positions, anticipating continued dollar weakness and attractive returns, particularly in Asian and Latin American markets; this trend is expected to drive significant inflows into emerging market bonds, as evidenced by April's $8.92 billion investment in South Korea, India, Indonesia, Thailand, and Malaysia.

Analysis

The U.S. dollar's weakness, evidenced by an 8.5% year-to-date decline in the dollar index to 99.30 and its first drop below the 100 mark in nearly two years, has established it as the preferred funding currency for emerging market carry trades, supplanting traditional options like the Japanese yen or Swiss franc. This shift is largely attributed by fund managers to U.S. trade policies under the Trump administration stoking recession concerns and a revised outlook on 'U.S. exceptionalism,' as stated by Vontobel. Consequently, asset managers such as Vontobel and M&G Investments are increasing allocations to dollar-funded carry trades in currencies like the Indonesian rupiah (1.2% three-month carry), Indian rupee (2% carry), Brazilian real (9% carry with 8.1% implied volatility), Philippine peso, and Mexican peso, anticipating continued dollar depreciation. The South Korean won also demonstrates appeal, having rallied 6.7% against the dollar this year. This strategy is fueling significant capital inflows into emerging markets, highlighted by $8.92 billion in net bond purchases across South Korea, India, Indonesia, Thailand, and Malaysia in April—the largest monthly inflow since August of the prior year—with South Korea alone attracting $7.91 billion. Goldman Sachs confirms heightened client interest, terming carry trades 'a big theme,' while ING Bank anticipates this trend may intensify over the summer if market volatility remains subdued. Furthermore, Turkey's orthodox monetary policy and 46% benchmark rate are drawing interest for carry trades, as noted by AGF Investments, though this comes with specific country risks. The proliferation of these trades is itself a factor that could perpetuate U.S. dollar weakness.

Key Decisions for Investors

• Investors should assess opportunities in U.S. dollar-funded emerging market carry trades, focusing on currencies offering attractive risk-adjusted yields, such as the Indian rupee and Indonesian rupiah, while approaching higher-yielding but more volatile currencies like the Brazilian real with appropriate risk management.
• Closely monitor U.S. economic data, Federal Reserve communications, and trade policy announcements, as these are key determinants of U.S. dollar strength and the ongoing viability of these carry trade strategies.
• Evaluate the potential in Turkish lira carry trades, given the central bank's commitment to orthodox monetary policy and high interest rates, but ensure thorough due diligence on Turkey's specific geopolitical and economic vulnerabilities.
• Recognize that the increasing popularity of dollar-funded carry trades may lead to crowded positions, heightening the risk of abrupt market corrections should U.S. dollar sentiment or broader market conditions shift adversely.