Carry trades in emerging markets, funded in dollars, have now posted positive returns for seven consecutive quarters, marking the longest winning stretch since 2008, according to Bloomberg data from August 23. Behind this run lies a straightforward logic, as described by Cathy Hepworth, head of PGIM's emerging markets debt team: "Carry, carry, carry." She notes, "It's a carry world," because "there's a wall of money looking for yield."

The core driver of these inflows isn't a rally in any single asset, but rather an extreme rebalancing of global liquidity between low-yielding and high-yielding assets. Breaking down the returns, interest rate differentials and currency movements form a dual engine. Since the end of 2024, the strategy has delivered cumulative returns of roughly 22%, compared to just 5.9% for US Treasuries, 14% for emerging market sovereign dollar bonds, and 10% for corporate bonds over the same period—making carry returns nearly four times those of US debt.

The PGIM team, which manages $1.5 trillion in assets, points out that the traditional approach involves borrowing in low-yield currencies like the dollar, yen, or euro, and then converting those funds into high-yield currencies such as the Turkish lira to purchase bonds, with interest returns that can exceed 40%. However, what truly amplifies the gains is currency movement: the dollar has weakened against emerging market currencies outside Asia, while also depreciating against funding currencies like the euro and the Swiss franc.

Colombia presents the most extreme case, where 12% bond returns were compounded by a 45% gain in the spot exchange rate. Even in Turkey, where the lira fell 26% against the dollar, yields above 32% on 10-year local currency bonds ensured investors remained profitable. Over the past 12 months, dollar-funded carry trades have earned 48% on the Colombian peso, 23% on the Turkish lira, 21% on the Brazilian real, 19% on the Mexican peso, and 18% on the South African rand.

This cross-currency long-short combination means that even when some currencies depreciate, the overall portfolio can still cover losses through high interest income and generate excess alpha. Recent market turbulence has put the strategy's resilience to the test. In early July, carry capital visibly shifted from developed markets to emerging markets, with the dollar falling out of favor; on July 23, the yen dropped to a multi-decade low. In early August, the US and Japan conducted a coordinated currency intervention, but the impact was far smaller than the August 2024 episode that sent the Bloomberg emerging market FX carry risk premium index down 4%—this time, the index only slipped about 1%.

The reason lies in a shift in funding currencies: the yen's role has been taken over by the euro, the Swiss franc, and the dollar. Thierry Larose, a portfolio manager at Swiss asset manager Vontobel, says "the threshold for a disorderly unwind is higher than we thought just a few weeks ago," and he continues to run carry trades while avoiding the yen. The intervention failed to reverse the yen's trend, with the currency returning to the 159–160 range by mid-August. While hedge funds' yen short positions were halved to 59,526 contracts, some carry traders have used the rebound to rebuild short positions. On August 17, the emerging market currency index hit a record high of 1906.98, showing that bullish momentum remains intact.

Looking ahead, risks center on Federal Reserve policy and trade crowding. This Wednesday, the US Treasury announced an increase in long-dated bond buybacks. Daniel Von Ahlen, macro strategy head at T.S. Lombard, notes that "the US government appears to have a very low tolerance for rising bond yields," which has catalyzed long positions in emerging market carry, and his firm's indicators have "improved again." Kamakshya Trivedi, chief FX and emerging markets strategist at Goldman Sachs, believes "improving inflation is enough for the Fed to stay on hold," but warns that rising long-end rates pose a threat. Ning Sun, senior emerging markets strategist at State Street, says US data is not yet weak enough to reverse risk appetite.

However, crowding has become a potential concern, and the strategy could fall victim to its own success. Supporting factors include Latin American and Eastern European central banks maintaining high rates to curb inflation, as well as Middle East tensions and elevated energy prices preventing easing. Alejo Czerwonko, chief investment officer for emerging markets Americas at UBS, prefers euro and Canadian dollar funding while going long the South African rand and Mexican peso. PGIM's Hepworth favors frontier markets in sub-Saharan Africa, along with Turkey, Colombia, and Brazil. This marks the first time since the 2008 financial crisis that emerging market carry trades have shown such a persistent structural advantage—but if macro expectations reverse, the risk of a stampede could escalate quickly.