Oil price surge becomes a "booster"? Amidst the flames of war, commodity currency arbitrage trades see their strongest start in three years.

Oil price surge becomes a "booster"? Amidst the flames of war, commodity currency arbitrage trades see their strongest start in three years.

The situation in the Middle East is impacting global assets, but currency carry trades are strengthening against the trend, becoming one of the few standout strategies in a turbulent market.

Oil prices have surged to multi-year highs due to warfare, benefiting commodity-exporting countries’ currencies and providing extra support for carry trades. Some strategies have already achieved returns of over 6% this year, marking the strongest start since 2023. Meanwhile, gains in US Treasuries this year have been wiped out, and stock markets continue to face pressure.

A carry trade portfolio funded in yen and buying a basket of currencies including the Brazilian real, Colombian peso, and Turkish lira has delivered returns of over 2% since the outbreak of hostilities. Leah Traub, head of the currency team at Lord Abbett & Co, said, The main reason for the robust performance of currency carry trades is commodities, as certain high-yield currencies benefit directly from rising oil and gas prices.

Oil-producing countries like Brazil have become top targets for capital. With a benchmark interest rate as high as 15%, coupled with rising oil production and export revenue, Brazil is one of the preferred battlegrounds for arbitrage trades. Macquarie Group strategists pointed out, Going long oil-producing countries’ currencies that are far from conflict zones is particularly advantageous in the current environment.

However, risks should not be overlooked. Citigroup strategists closed their last recommended emerging market carry positions last week, citing the high uncertainty and volatility caused by warfare. Analysts warn that if risk aversion triggers a sharp yen appreciation or Japanese authorities intervene, carry trade gains may quickly evaporate.

Oil Prices as Key Driver of Carry Trades

The core logic of carry trades is borrowing low-interest currencies and investing in high-interest currencies to earn the interest differential. In the current market environment, commodity price movements are playing an increasingly important role.

"The main reason for the resilient performance of FX carry trades is commodities," said Leah Traub, portfolio manager and head of the currency team at Lord Abbett & Co., which manages around $248 billion in assets. "Some high carry currencies benefit from rising oil and gas prices."

Against this backdrop, traders prefer borrowing currencies from countries with rising energy costs (such as the yen) and investing in currencies of economies benefiting from energy exports. A popular portfolio involves borrowing yen and buying a basket of currencies including the Brazilian real, Colombian peso, and Turkish lira. According to Bloomberg-compiled data, this portfolio has returned over 2% since the Middle East conflict, with cumulative returns exceeding 6% this year.

Brazil as Core Target for Carry Trades

Among emerging markets, Brazil has become the top pick for carry traders due to its high interest rates and dual advantage in oil and gas exports.

Brazil’s benchmark interest rate currently sits at 15%. Its one-month carry volatility ratio—a key measure of the strategy’s appeal—remains high compared to similar economies. São Paulo-based hedge fund Legacy Capital Gestora de Recursos Ltda., which manages around $3 billion in assets, continues to take positions in the real based on this logic and funds related trades by shorting counter-cyclical developed market currencies.

"We are sticking with our current positions," said Felipe Guerra, the company’s co-founder and chief investment officer.

Macquarie Group’s New York strategist Thierry Wizman holds a similar view: "I wouldn’t shy away from carry trades going long currencies of oil-producing countries that are far away from conflict zones. Brazil has continually increased oil production in recent years and is particularly benefiting."

Emerging Markets Supported by Structural Factors

Beyond oil prices, some investors believe emerging market currencies’ resilience is backed by deeper structural factors.

Anna Wu, cross-asset investment strategist at Van Eck Associates in Sydney, said: "Over the past year or so, emerging markets have performed steadily overall, underpinned by structural supports like high growth, monetary policy, and a weakening US dollar."

The yen’s trend is also a crucial pillar supporting carry trades. As a traditional safe haven, the yen has not maintained strength amid recent geopolitical conflicts. The Bank of Japan has kept a relatively loose policy stance, prolonging the low interest rate environment and consolidating the yen's status as the global preferred funding currency, even as market volatility has risen significantly.

Matthias Scheiber, senior portfolio manager at Allspring Global Investments, pointed out: "From past experience, people would expect the yen to appreciate on risk-aversion inflows, but Japan’s export exposure and the Bank of Japan’s cautious policy have actually helped the yen remain weak."

Risks Remain, War Developments Are Key Variable

Although carry trades are currently performing strongly, market participants generally emphasize that The duration of the conflict will be the core variable determining whether this strategy can continue.

Noureldeen Al Hammoury, chief market strategist at Equiti Group in Dubai, warned: "If the conflict escalates and triggers global risk aversion, investors may quickly rush to buy back yen to unwind carry positions, potentially causing sharp yen appreciation and violent market swings."

In addition, investors who use the US dollar as a funding currency for carry trades have faced losses this month, as the dollar strengthened against most emerging market currencies. According to Bloomberg, Citigroup strategists Dirk Willer and Adam Pickett closed their last batch of recommended emerging market carry positions last week due to the high uncertainty and volatility brought by the conflict.

Currently, the unusual market pattern created by the conflict continues to provide a lifeline for carry trades, especially since no signs of large-scale capital repatriation by Japanese investors have emerged. But analysts warn that once the market direction changes, the fragility of this strategy will be quickly exposed.

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