Forex Carry Trades Thrive on Oil Surge Amid Geopolitical Tensions

Forex Carry Trade Strategies Find Tailwind in Soaring Oil Prices

In the colossal foreign exchange market, a daily theatre of operations exceeding $9.5 trillion, a widely embraced trading strategy is currently receiving a significant boost from surging oil prices. This surge, while creating ripple effects across other global assets, is proving to be a powerful catalyst for carry trade strategies.

Capitalizing on Interest Rate Differentials and Commodity Booms

The core mechanism of a carry trade involves sourcing funds from countries with low interest rates and deploying them into economies offering higher yields. In the current environment, certain segments of this strategy are experiencing their most favorable returns in three years. The proximate cause for this upswing is the geopolitical conflict, which has ignited a rally in oil prices. This is occurring even as the same tensions have induced sharp volatility in equity and bond markets, even erasing all of the 2026 U.S. Treasury gains.

Leah Traub, portfolio manager and head of FX at Lord Abbett & Co., which oversees approximately $248 billion in assets, identifies "commodities" as the primary driver behind the robust performance of FX carry trades. She notes that "certain high-yield currencies are benefiting from the rise in oil and natural gas prices."

Trade Mechanics and Commodity-Linked Currencies

Traders are actively exploiting this dynamic by borrowing funds from economies facing greater cost pressures from rising energy expenses, such as Japan, and subsequently investing in economies that are net beneficiaries of higher energy prices. A common practice involves pairing the currencies of commodity-exporting nations with other high-yielding currencies to mitigate the risk of single-currency exposure.

According to data compiled by Bloomberg, a popular approach entails borrowing the Japanese yen and acquiring a basket of currencies that includes the Brazilian real, Colombian peso, and Turkish lira. Since the onset of Israeli attacks on Iran, this strategy has yielded over a 2% return, and year-to-date, the returns have surpassed 6%, marking its strongest start since 2023.

Carry Trade Resilience Amidst Regional Conflict

As conflict propels crude oil prices to multi-year highs, commodities are assuming an increasingly pivotal role in global markets. Elevated oil prices, coupled with relatively elevated interest rates in certain economies, are helping to offset the market volatility that typically erodes carry trade profits.

In Brazil, the one-month interest rate differential-to-volatility ratio – a key metric for the strategy's attractiveness – remains elevated compared to other nations. This has encouraged hedge funds like Legacy Capital Gestora de Recursos Ltda., based in São Paulo, to invest in currencies such as the real, as Brazil's benchmark interest rate holds firm at 15%.

The firm, managing around $3 billion in assets, finances these trades by shorting counter-cyclical developed market currencies.

Felipe Guerra, co-founder and chief investment officer at Legacy Capital, stated: "We will continue to hold existing positions."

Brazil, a favored destination for carry trades, continues to benefit from its burgeoning domestic oil production and export revenues.

Thierry Wizman of Macquarie Group comments: "I wouldn't give up on well-matched carry trades, which is going long on oil-producing countries' currencies that are away from the conflict." He adds, "For example, this is particularly beneficial for Brazil, which has seen its oil production grow in recent years."

Emerging Market Currencies Outperform on Interest Rates

A broader set of factors is seen by some investors as underpinning emerging market currencies, including relatively robust economic growth and interest rates that remain significantly higher than those in developed markets.

Anna Wu, cross-asset investment strategist at VanEck Associates, notes that "emerging markets as a whole have been strong over the past year or so, supported by structural factors like high growth, monetary policy, and a generally weaker dollar."

The Japanese yen, the most widely used funding currency globally, has also played a significant role. While typically considered a safe-haven currency during geopolitical turmoil, the yen has failed to achieve sustained appreciation this time. Due to the Bank of Japan's relatively accommodative monetary policy, Japan's low-interest-rate environment continues to make it a preferred funding currency, even amid heightened volatility.

Duration of the Conflict is Key

Admittedly, a substantial appreciation of the Japanese yen, whether driven by safe-haven flows or policy intervention by Japanese authorities, could swiftly erase carry trade profits. Noureldeen Al Hammoury, chief market strategist at Equiti Group, explains: "If the conflict escalates and triggers a global flight to safety, investors typically rush to buy back yen to unwind their carry trades. This could lead to a violent yen appreciation and extreme market volatility."

Furthermore, emerging market risks persist, particularly with the evolving news flow related to the war. This month, investors using the U.S. dollar for carry trades faced losses as the greenback strengthened against most emerging market currencies.

Investors and strategists emphasize that the duration of the conflict will be the decisive factor in determining the sustainability of carry trade positions.

Strategists at Citigroup, including Dirk Willer and Adam Pickett, unwound their last recommended emerging market carry trade positions last week due to the high uncertainty and volatility associated with the conflict.

However, for the time being, this unusual market landscape created by the war continues to support carry trades, especially as Japanese traders have yet to signal a significant repatriation of funds.

Matthias Scheiber, senior portfolio manager at Allspring Global Investments, observes: "Historically, the yen should have strengthened with a flight to safety." Instead, he notes, "Japanese export exposure and the Bank of Japan's cautious policy stance 'helped the yen remain weak.'"