How Trump’s Tariffs Are Impacting Emerging Market Carry Trade Strategies


How global volatility, tariffs, and inflation affect emerging market carry trades
/ Picture ⓒ Alex Brandon / AP

Currency Volatility’s Impact on Emerging Market Carry Trades: What Investors Need to Know

The financial landscape in 2025 is marked by heightened volatility, trade tensions, and shifting interest rate policies that are reshaping the dynamics of emerging market carry trades. As global investors navigate the complexities of currency fluctuations, US tariffs, and inflationary pressures, the profitability of carry trades is increasingly under scrutiny. This article explores how these developments are influencing currency markets, the risks involved, and potential strategies for managing emerging market carry trades.

What Are Carry Trades and Why Are They Popular?

Carry trades are a well-established investment strategy in which investors borrow money in low-interest-rate currencies—such as the Japanese yen or Chinese yuan—and invest in higher-yielding currencies of emerging markets. This strategy allows investors to capitalize on the interest rate differential between countries, which has traditionally provided substantial returns when interest rates in developed economies remain low.

Emerging market currencies like the Mexican peso, Brazilian real, and Turkish lira are often seen as attractive targets for carry trades due to their higher yields. However, these trades come with inherent risks, especially in times of market volatility or when geopolitical tensions threaten global trade.

How Trade Tensions and Trump’s Tariffs Affect Currency Volatility

The US’s tariff threats against major trading partners, particularly China and Mexico, have introduced significant volatility in the value of these countries’ currencies. Trump's proposed 25% tariff on Mexican goods and a 10% tariff on Chinese imports have put additional pressure on the Mexican peso and Chinese yuan, both of which are commonly used in carry trades.

When tariffs are imposed or even threatened, they often lead to sudden devaluation in emerging market currencies. This undermines the returns for investors in carry trades, making these markets less attractive. As the US administration continues to fluctuate between imposing tariffs and easing tensions, the instability caused by these actions makes it challenging to predict the long-term viability of these trades.

The US Dollar: A Shifting Source of Funding for Carry Trades

Historically, the US dollar has been a preferred currency for funding carry trades. Its stability and liquidity have made it a reliable source of financing for investors borrowing in dollars. However, rising inflation and potential policy changes under Trump’s administration are challenging the dollar’s dominance in this space.

Higher inflation can reduce the real value of returns, especially for those using the dollar to fund their carry trades. As inflationary pressures mount, the Federal Reserve may adjust its monetary policies, slowing or halting interest rate cuts. Consequently, the rising cost of borrowing in US dollars makes this funding source less attractive compared to other currencies, such as the Japanese yen or Swiss franc.

The Risks of Yen-Funded Carry Trades Amid Japan’s Rate Hike

The Bank of Japan’s recent shift in monetary policy, including signaling the potential for interest rate hikes, presents a challenge to yen-funded carry trades. Historically, the Japanese yen has been a popular funding currency for carry trades due to Japan’s ultra-low interest rates. However, as the BOJ moves toward tightening policy, the value of the yen is expected to rise, increasing the cost of borrowing in yen.

Investors who have relied on yen-funded carry trades must now contend with the possibility of a stronger yen, which could erode the profitability of these investments. The narrowing interest rate differential between Japan and the US means that the returns on yen-funded trades could diminish, making them less appealing in the current global economic environment.

Evaluating the Risk-Reward Ratio for Emerging Market Carry Trades

The risk-reward ratio for emerging market carry trades has significantly shifted due to increased volatility in global financial markets. A basket of currencies tracked by Bloomberg has shown a sharp decline in risk-adjusted returns, reflecting the growing instability in the markets. Emerging market currencies, such as the Mexican peso, Brazilian real, and Turkish lira, are increasingly under pressure from both domestic economic factors and external trade issues.

While high-yielding currencies may still attract investors, the potential for large swings in currency values, driven by geopolitical tensions and inflationary fears, makes carry trades riskier than in previous years. Investors must carefully weigh the potential returns against the heightened risks of market disruptions.

Which Emerging Market Currencies Are Still Attractive for Carry Trades?

While the risks associated with emerging market carry trades have grown, there are still opportunities for savvy investors. Goldman Sachs points to Latin American currencies, such as the Brazilian real and Mexican peso, as potentially attractive options. These currencies may have already priced in their domestic fiscal challenges, and a rebound could be on the horizon if trade tensions ease.

On the other hand, Asian currencies such as the Chinese yuan are under more pressure due to ongoing trade negotiations and potential tariff increases. While carry trades funded by Asian currencies may still offer higher yields, the geopolitical risks involved make these trades more uncertain.

Emerging markets in Africa and the Middle East, including South Africa and Egypt, are also showing signs of promise. Countries with improving macroeconomic fundamentals and lower inflation rates may present less risky opportunities for carry trades in the coming months.

How Investors Can Adapt to the Changing Carry Trade Landscape

As the carry trade landscape evolves, investors must adapt by reassessing their strategies. Key adjustments may include:

  1. Diversification: Instead of focusing solely on Latin American or Asian currencies, investors should consider diversifying their portfolios across regions with more stable fiscal and monetary policies.
  2. Monitoring Tariff Developments: Ongoing trade negotiations between the US and major emerging markets should be closely monitored, as the imposition of tariffs can cause sudden and unpredictable currency devaluations.
  3. Interest Rate Differentials: The narrowing of interest rate differentials between countries, particularly the US and Japan, should be factored into any carry trade decision, as this can impact the profitability of borrowing in certain currencies.

Summary

Emerging market carry trades are facing increasing challenges due to the volatile global economic landscape. Tariff threats, rising inflation, and shifting interest rate policies are driving uncertainty and reducing the attractiveness of these trades. Investors must navigate this complex environment by staying informed, diversifying their investments, and adapting to new risks. While opportunities still exist, the strategy’s viability depends on how well investors can manage these evolving risks.

Q&A Section

Q1: What is a carry trade?
A carry trade involves borrowing in low-interest-rate currencies and investing in higher-yielding currencies, often from emerging markets. This strategy capitalizes on interest rate differentials.

Q2: How do Trump's tariffs impact emerging market currencies?
Trump’s tariffs can cause currency devaluation in emerging markets, especially in countries like Mexico and China. This creates volatility and reduces the profitability of carry trades involving these currencies.

Q3: Why is the US dollar less attractive for funding carry trades?
Rising inflation in the US and potential shifts in Federal Reserve policy make the dollar less attractive for carry trades. The higher cost of borrowing in US dollars reduces the appeal for investors.

Q4: Are yen-funded carry trades still viable?
Yen-funded carry trades are becoming less attractive due to Japan's potential interest rate hikes. A stronger yen could erode the profitability of these trades, making them riskier.

Q5: Which emerging market currencies are still worth investing in?
Currencies like the Brazilian real and Mexican peso may rebound, while currencies like the Chinese yuan are facing pressure due to trade tensions. Investors should look at macroeconomic fundamentals and geopolitical risks when making their choices.


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