Dollar’s Falling Volatility Creates Appeal as Carry-Trade Funder

The dollar is increasingly appealing as a funding currency for carry trades into emerging market currencies due to its significantly reduced volatility compared to traditional alternatives like the euro and yen. This diminished sensitivity to risk events, influenced by the US fiscal situation and tariffs, is evidenced by a falling 90-day correlation between dollar-funded EM carry trades and the S&P 500, contrasting with five-year highs for euro and yen-funded trades.

Analysis

The US dollar is emerging as an increasingly attractive funding currency for carry trades into emerging markets, a shift driven by its declining volatility relative to traditional funders like the euro and yen. According to a Bloomberg analysis, this change is linked to the current US fiscal situation and tariff policies, which have made the greenback less sensitive to broad risk events. This desensitization is empirically supported by a significant drop in the 90-day correlation between a dollar-funded carry trade into six emerging-market currencies and the S&P 500, a key proxy for risk sentiment. In stark contrast, the correlations for similar trades funded by the euro and yen have surged to five-year highs, making them less stable as funding sources in a fluctuating risk environment.

Key Decisions for Investors

• Investors utilizing carry trade strategies should evaluate shifting their funding currency from the euro or yen to the US dollar to capitalize on its lower volatility and reduced correlation to global risk sentiment.
• It is crucial to monitor the correlation between dollar-funded carry trades and the S&P 500, as a sustained increase would signal an erosion of the dollar's current appeal as a stable funding currency.
• Investors should recognize that the viability of this strategy is contingent on the persistence of current US fiscal and trade policies, as any significant changes could alter the dollar's risk characteristics and affect the trade's fundamentals.