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Geopolitical uncertainty hits carry trade strategy

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 Strategists at TD Securities have observed that the unwinding of the carry trade—a strategy where investors exploit interest rate differentials between countries—is gaining traction among clients, according to a report by MarketWatch. 

On Monday, TD Securities strategists Mark McCormick, Jayati Bharadwaj, Ray Ng and Alex Loo said in a note that the foreign exchange market had been in a “dreamlike state” regarding volatility. 

They wrote that “the unwinding of the carry trade has been a major talking point with clients recently”. 

“A successful carry trade requires two conditions: low volatility and interest-rate divergence. 

“Both are now shifting, making the US dollar the best hedge against rising risks.” 

Just a month ago, this strategy was highly recommended across global foreign-exchange markets, with expectations of benefiting from low volatility and divergent interest-rate paths among central banks. 

However, the landscape shifted dramatically earlier this month. A sharp decline in the Mexican peso, prompted by a landslide election victory for Mexico’s ruling party, triggered a rapid unwinding of the carry trade. This led to the largest daily drop in Mexican equity ETFs in over four years on 3 June, while the peso experienced its worst daily performance against the US dollar since June 2020. 

The situation intensified last week as federal funds futures traders began pricing in the possibility of up to two quarter-point rate cuts from the Federal Reserve this year, contrary to policymakers’ guidance of just one cut in 2024. This shift suggests the Fed might join global peers in lowering rates, moving away from the previous stance of maintaining higher interest rates between 5.25% and 5.5%. 

TD Securities noted that these events are part of a “complex, adaptive system” where isolated incidents can evolve into broader market problems. 

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