What’s going on here?
A sharp decline in Mexico’s peso following a significant election result has disrupted foreign exchange markets, impacting currencies in Hungary and Turkey this week.
What does this mean?
Investors often engage in carry trades by borrowing in low-
interest
-rate currencies, like the Japanese yen, and investing in higher-yielding currencies such as the Mexican peso. This strategy thrives when global interest rates diverge and market
volatility
is low. However, the peso’s 4.4% drop against the yen on Monday marked its largest decline since the COVID-19 crisis, signaling a rapid exit from this popular trading strategy. Continued market volatility was evident when the yen fell sharply against the dollar on Wednesday, forcing traders to rethink their approach. ING’s Chris Turner noted that the rise in emerging market FX volatility has led to global deleveraging in carry trades, leaving investors uncertain about their next steps.
Why should I care?
For markets: Volatility shakes traders’ confidence.
The recent fluctuations have prompted many investors to liquidate carry trades and adopt flat positions, though some core long-term trades remain but are significantly reduced. Observers like Chris Weston of Pepperstone suggest keeping a close eye on whether the peso-yen shakeout has largely played out. Aggressive moves, especially from Japanese traders, could provide further insights into the strategy’s future viability.
The bigger picture: Political shifts and FX volatility go hand in hand.
Claudia Sheinbaum’s anticipated landslide presidential win in Mexico significantly impacted the peso, raising concerns over potential constitutional reforms and US trade relations. Concurrently, India’s rupee stumbled amid signals that business-friendly Prime Minister Narendra Modi might lose his majority, adding to the volatility. These outcomes have increased turbulence in other emerging market currencies like Hungary’s forint and Turkey’s lira. With speculation around a possible Bank of Japan rate hike in July, ongoing market interventions, and the yen’s 34-year lows, the situation remains complex and challenging for carry trade strategies.
