Dollar carry trades set to trounce world’s booming stock markets

The dollar is re-emerging as a highly appealing asset, primarily due to the resurgence of carry trades involving borrowing in low-yielding currencies like JPY and CHF to invest in dollars. Bloomberg calculations suggest this strategy offers superior risk-adjusted returns compared to European stocks and Chinese bonds, particularly given reduced dollar volatility and growing concerns over stretched equity valuations, including a negative US equity risk premium. This renewed dollar attractiveness is poised to drive significant capital flows and influence global markets, though risks such as faster-than-expected Fed rate cuts exist; however, persistent inflation could support a slower easing path, potentially sustaining dollar carry appeal into 2026.

Analysis

The U.S. dollar is re-establishing itself as a premier global asset, driven by a resurgence in carry trade strategies. Bloomberg calculations indicate that borrowing in low-yielding currencies like JPY and CHF to invest in USD offers superior risk-adjusted returns compared to European equities and Chinese government bonds. This renewed appeal is supported by a 3% rebound from its September low, despite a 7% year-to-date decline, and is expected to drive significant capital flows globally.

This shift occurs amidst growing concerns over stretched equity valuations, with the S&P 500 up over a third from April lows and a negative US equity risk premium, implying no risk-adjusted return for US stocks. Chinese stocks offer a mere 0.23% return per volatility point, significantly less than the 0.54% from the low-risk dollar carry trade. A sharp reduction in dollar volatility, partly due to a prolonged government shutdown, further enhances the attractiveness of unhedged dollar asset investments.

While the dollar carry trade presents a compelling opportunity, it is not without risks, primarily a potential for faster-than-expected Fed rate cuts eroding its advantage. However, persistent US inflation at 3% in September, above the Fed's 2% target, suggests a slower easing path could protect carry returns. Strategists from JPMorgan, Deutsche Bank, and Wells Fargo anticipate the dollar remaining an attractive carry asset, potentially sustaining these strategies into 2026, contingent on a resilient macro and financial market backdrop.

Key Decisions for Investors

• Investors should consider increasing exposure to USD-denominated assets, particularly through carry trade strategies, given the superior risk-adjusted returns compared to other major markets.
• Closely monitor Federal Reserve communications on interest rates and inflation data, as a faster pace of rate cuts or a significant decline in inflation could diminish the attractiveness of dollar carry.
• Re-evaluate allocations to global equities, especially US and Chinese stocks, in light of their negative or significantly lower risk-adjusted returns compared to the dollar carry trade.