Commerzbank’s Michael Pfister says G10 and emerging market (EM) carry trades have shown strong paper gains since the start of 2025. He links this to Iran-related market moves and to high-yield currencies such as the Brazilian real and Mexican peso.
He says a G10 carry strategy outperformed pure interest income in the first quarter. He attributes this to exchange rate moves that supported the trade, alongside interest income.
Carry Performance Depends On Market Conditions
Pfister says there is no empirical evidence that carry strategies deliver systematic long-term outperformance. He notes that carry can do well in the short term when currency moves align with the position.
He adds that EM carry strategies have become more popular in recent years. The Bloomberg EM Carry Trade Index has posted exceptionally strong performance since the beginning of 2025.
He warns that recent EM carry returns are largely driven by interest income. He says the exchange rate component is still recovering from weak performance in 2024.
We have to remember that the strong paper gains from carry trades in early 2025 were helped by specific geopolitical events and a favorable interest rate environment. That landscape is now changing as major central banks have shifted their policy stance from the aggressive hikes we saw previously. This narrows the yield gaps that make the strategy attractive in the first place.
Hedging Carry Trades In Higher Volatility
For emerging market trades, we must be especially cautious because performance was largely due to high interest income, while the currencies themselves were just recovering from a poor 2024. That recovery now appears to be fading, as we see that the Mexican Peso, a favorite for this strategy, has weakened by over 3% against the dollar year-to-date. This currency depreciation is starting to eat into the high interest rate gains.
The low-volatility environment that helps these trades has also shifted, with the VIX index now consistently holding above 18, a notable increase from the calmer periods of 2025. In such an environment, sudden exchange rate moves can quickly erase months of accumulated interest payments. Historically, carry trades perform poorly when market volatility rises unexpectedly.
Therefore, we should consider using options to hedge our exposure in popular pairs like the USD/MXN. Buying put options on the high-yield currency provides a clear floor, limiting our downside if the currency suddenly weakens in the coming weeks. This allows us to define our risk while still participating in the trade, which is prudent given the changing market conditions.
