Morgan Stanley: Yen appreciation is not enough to disrupt emerging market carry trades

The yen has strengthened significantly recently, but this is not enough to shake the foundation of emerging market carry trades. Morgan Stanley strategists believe that the strategy remains resilient as long as no additional catalysts emerge that trigger broader volatility.

In a recent research report, the team led by James Lord, Global Head of FX and Emerging Markets Strategy at Morgan Stanley, pointed out that the performance of carry trades depends more on the overall trend of global currency volatility, the outlook for global economic growth, stock market performance, and the fundamental logic of emerging market economies themselves, rather than the single movement of the yen exchange rate.

“Global growth, global equity performance, and bottom-up trends in major emerging markets have a far greater impact on emerging market carry trades than the yen’s exchange rate,” the team wrote. “We maintain a constructive outlook on these aspects.”

The market is showing signs of resilience. Although the Brazilian real and Colombian peso have depreciated by 5.1% and 3.4% respectively against the Japanese yen since July 29, they have appreciated by 0.7% and 2.4% respectively against the US dollar, indicating that the overall pressure on emerging market currencies is relatively manageable.

The yen rose to its highest level in more than six months as expectations of an interest rate hike intensified.

The yen rose as high as 152.89 against the dollar on Tuesday, its strongest level since mid-February, before closing at 153.46. Gains have since narrowed. This surge was driven by traders increasing their bets on a Bank of Japan interest rate hike and remaining wary of further actions by the authorities to support the yen.

The core logic of arbitrage trading lies in borrowing low-interest currencies and investing the funds in high-interest assets to profit from the interest rate differential. The Japanese yen has long been one of the primary funding currencies for this strategy, and the Bank of Japan's anticipated interest rate hikes therefore pose a potential challenge to this trade.

Diversified funding currencies and more flexible arbitrage trading structures

Morgan Stanley strategists point out that investors are actively diversifying their funding sources, with the euro and Swiss franc increasingly becoming alternatives for financing high-yield asset positions. This structural shift means that arbitrage trading is less sensitive to fluctuations in a single funding currency, and the overall risk resistance of strategies has correspondingly increased.

According to a previous Bloomberg report, emerging market arbitrage trading has recently recorded its longest winning streak since 2008, with market participation remaining high.

Morgan Stanley's team maintains a positive view on emerging markets, advising investors to buy on dips. "Bottom-up fundamental support, attractive spreads, and resilient global growth will continue to attract investors to this asset class," the strategists said.

The team emphasizes that the real threat to emerging market carry trades lies in systemic shocks that could trigger broader market volatility, rather than the yen's temporary appreciation itself. Given that global growth expectations have not yet shown a significant deterioration, the basic logic of this strategy remains valid.

Risk Warning and DisclaimerInvesting involves risk; please exercise caution. This article does not constitute personal investment advice and does not take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their specific circumstances. Any investment decisions made based on this information are at your own risk.