BNY reports that tighter global financial conditions and softer risk appetite are putting pressure on emerging market (EM) FX carry trades. Holdings in FX carry trades have peaked, and high-yielding currencies are seeing outflows.
Latin American currencies face risk due to elevated holdings, which can increase the chance of a sharp unwind. The report indicates that further interest rate rises may be needed to limit disorderly moves.
Global Portfolio Positioning And Allocation Trends
EM allocations remain low in global portfolios. The report adds that low weightings, cheaper valuations, and favourable exchange rates, especially in APAC, may support gradual increases in allocations.
The main factor to watch is US-led changes in financial conditions. The report says that support from expectations of US Federal Reserve easing may be nearing its limit if US data turns.
The environment for FX carry trades is getting tougher as global financial conditions tighten. After January’s US jobs and inflation reports both came in hotter than expected, the market is now pricing out any immediate Federal Reserve rate cuts. This means we should be cautious about holding high-yielding emerging market currencies.
We are particularly concerned about Latin American currencies, where our holdings became elevated after the strong performance we saw through much of 2025. The Mexican Peso has already weakened past 18.00 to the dollar this month, a level not seen in half a year, showing early signs of this unwinding. We should consider buying put options on the peso or the Brazilian real to hedge against a sharper drop.
Positioning And Hedging Considerations
The main test for all emerging markets will be adjustments led by the United States. With the Fed likely on hold, the path of least resistance for the US dollar appears to be higher. The risk of a “disruptive unwinding” suggests we should prepare for higher volatility in these currency pairs in the coming weeks.
However, we see potential in Asia, where allocations are not as crowded and valuations look better. For instance, India’s manufacturing sector continues to show robust expansion, with the latest PMI data for January hitting a four-month high of 56.9. This could support a strategy of being long certain Asian currencies against our short positions in Latin America.
