Oil Price Surge as a "Booster"? Amid Conflict, Commodity Currency Carry Trades See Strongest Start in Three Years

Middle Eastern tensions impact global assets, but forex carry trades are strengthening against the trend, becoming one of the few strategies performing well in turbulent markets.

Oil prices have surged to multi-year highs due to the conflict, benefiting commodity-exporting currencies and providing additional support for carry trades. Some strategies have already returned over 6% this year, marking the strongest start in 2023. Meanwhile, U.S. Treasury yields have been fully erased this year, and stock markets remain under pressure.

A carry trade basket involving yen financing and buying currencies such as the Brazilian real, Colombian peso, and Turkish lira has yielded over 2% since the outbreak of the conflict. Leah Traub, head of currency at Lord Abbett & Co., said, The main reason forex carry trades are holding up well is due to commodities, with some high-yield currencies directly benefiting from rising oil and gas prices.

Oil-producing countries like Brazil are becoming favored targets for funds. Brazil’s benchmark interest rate is as high as 15%, and increasing oil production and export revenues make it a top choice for arbitrage trading. Macquarie strategists note that long positions in currencies of oil-producing countries away from the conflict are especially 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 the conflict. Analysts warn that if risk aversion triggers a sharp yen appreciation or Japanese authorities intervene, profits from carry trades could evaporate quickly.

Oil Prices Drive Carry Trade

The core logic of carry trades is borrowing low-interest-rate currencies to invest in high-interest-rate currencies to earn the interest spread. In the current market, commodity prices are playing an increasingly important role.

“Forex carry trades are performing so steadily mainly because of commodities,” said Leah Traub, portfolio manager and head of currency at Lord Abbett & Co., which manages about $248 billion. “Some high-yield currencies benefit directly from rising oil and gas prices.”

In this context, traders tend to borrow currencies of energy-importing countries with high energy costs (like yen) and invest in currencies of energy-exporting economies. A popular combination is borrowing yen and buying a basket of currencies including the Brazilian real, Colombian peso, and Turkish lira. According to data compiled by Bloomberg, this basket has returned over 2% since the Middle Eastern conflict began, with a total return exceeding 6% this year.

Brazil as a Core Carry Trade Target

Among emerging markets, Brazil stands out as a top target for carry traders due to its high interest rates and oil and gas export advantages.

Brazil’s benchmark rate is currently 15%, and its one-month interest rate differential—a key indicator of the strategy’s attractiveness—remains high compared to similar economies. São Paulo-based hedge fund Legacy Capital Gestora de Recursos Ltda., managing about $3 billion, continues to position in the real based on this logic, also shorting counter-cyclical developed market currencies to fund related trades.

“We are holding our existing positions,” said co-founder and CIO Felipe Guerra.

Macquarie strategist Thierry Wizman shares a similar view: “I wouldn’t shy away from long positions in currencies of oil-producing countries away from conflict zones. Brazil has consistently increased its oil output in recent years, which benefits these positions.”

Structural Factors Support Emerging Markets

Beyond oil prices, some investors believe that the resilience of emerging market currencies is supported by deeper structural factors.

Anna Wu, cross-asset strategist at Van Eck Associates in Sydney, said, “Over the past year or so, emerging markets have performed steadily, supported by high growth, accommodative monetary policies, and a weakening dollar.”

The yen’s movement is also a key factor supporting carry trades. As a traditional safe-haven currency, the yen has not continued to strengthen amid the geopolitical conflict. The Bank of Japan maintains a relatively loose policy stance, allowing its low interest rates to persist and reinforcing the yen’s role as the world’s preferred funding currency, even as market volatility has increased.

Allspring Global Investments senior portfolio manager Matthias Scheiber noted, “Historically, one might expect the yen to appreciate due to safe-haven flows, but Japan’s export exposure and the Bank of Japan’s cautious stance have helped keep the yen weak.”

Risks Remain, Conflict’s Trajectory Is Key

Despite the strong performance of carry trades, market participants generally emphasize that the duration of the conflict will be a key variable in whether this strategy can continue.

Noureldeen Al Hammoury, chief market strategist at Equiti Group in Dubai, warned: “If the conflict escalates and triggers a global risk-off sentiment, investors will rush to cover yen positions, which could lead to sharp yen appreciation and market volatility.”

Additionally, investors using the dollar as funding currency have faced losses this month as the dollar has strengthened against most emerging market currencies. According to Bloomberg, last week Citigroup strategists Dirk Willer and Adam Pickett closed their final recommended emerging market carry positions, citing the high uncertainty and volatility caused by the conflict.

The abnormal market environment created by the war still offers room for carry trades, especially as Japanese investors have not yet shown signs of large-scale capital outflows. However, analysts warn that once market sentiment shifts, the fragility of this strategy will be quickly exposed.

Risk Warning and Disclaimer

        The market carries risks; investments should be made cautiously. This article does not constitute personal investment advice and does not consider individual user’s specific investment goals, financial situation, or needs. Users should consider whether any opinions, views, or conclusions herein are suitable for their particular circumstances. Invest at your own risk.