Carry trade comeback revives 2024 blowup fears, Goldman says

The carry trade — borrowing in low-yielding currencies to buy higher-yielding ones — has staged a comeback that Goldman Sachs says faces its best conditions since 2000, reviving fears that a sudden unwind could trigger a repeat of the 2024 market dislocation that erased billions in leveraged fund capital.

"The macro environment for carry is as favorable as we've seen in over two decades, with rate differentials wide and volatility suppressed," a Goldman Sachs strategist wrote in a note to clients dated July 10, according to a report.

The trade, which involves selling low-yielding currencies such as the yen and Swiss franc to fund purchases of higher-yielding emerging market currencies, has grown as central banks in developed economies maintain elevated rates while developing nations hold even higher benchmarks. The 2024 blowup occurred when a sudden shift in Bank of Japan policy triggered a rapid unwind, causing losses across leveraged hedge funds and spilling into broader markets.

The risk now is that the larger size of the trade makes any future unwind more disruptive. A sudden reversal could hit emerging market currencies hardest, with potential contagion into cross-asset risk appetite, according to the analysis.

Rate Differentials Drive the Return

The core driver of the carry trade's revival is the persistence of wide interest rate differentials between developed and emerging economies. While the Federal Reserve, European Central Bank, and Bank of Japan have held rates at elevated levels, many emerging market central banks maintain even higher policy rates to combat inflation, creating the spread that carry traders exploit.

Goldman Sachs's assessment that conditions are the most favorable since 2000 reflects both the magnitude of these differentials and the relative calm in FX volatility markets. Low volatility allows carry trades to generate steady returns without the risk of sudden exchange rate moves wiping out the interest income.

The 2024 Precedent and Systemic Risk

The 2024 blowup serves as a cautionary tale. That episode, triggered by an unexpected shift in Bank of Japan policy that sent the yen surging, forced leveraged hedge funds to unwind carry positions rapidly. The resulting losses cascaded through prime brokerage relationships and forced selling across asset classes.

The current environment shares some features with 2024 — compressed volatility, crowded positioning, and reliance on leverage — but also differs in key ways. Rate differentials are wider now, and markets have had more time to price in the risk of sudden policy shifts. Still, the larger scale of the trade means any unwind could be more disruptive.

For emerging market currencies, the stakes are particularly high. Countries that have attracted significant carry inflows could face sudden capital outflows if the trade reverses, pressuring their exchange rates and forcing central banks to respond with rate hikes or intervention.

This article is for informational purposes only and does not constitute investment advice.