Morgan Stanley: Yen Gains Not Enough to Upend EM Carry Trades

The yen has strengthened significantly recently, but that is not enough to shake the foundations of emerging-market carry trades. Morgan Stanley strategists believe that as long as no additional catalyst triggers broader volatility, the strategy remains resilient.

James Lord, head of global FX and emerging markets strategy at Morgan Stanley, and his team said in their latest research note that carry trade performance depends more on the overall direction of global currency volatility, global economic growth prospects, equity market performance, and the fundamental logic of emerging-market economies themselves, rather than on any single move in the yen.

"Global growth, global equity performance, and bottom-up trends in major emerging markets matter far more for EM carry trades than the yen," the team wrote. "On these fronts, we maintain a constructive view."

Signs of resilience are already emerging. Although the Brazilian real and Colombian peso have weakened 5.1% and 3.4% against the yen since July 29, they have strengthened 0.7% and 2.4% against the dollar, respectively, indicating that overall pressure on emerging-market currencies is relatively contained.

Yen Hits Over Half-Year High as Rate Hike Bets Rise

The yen briefly strengthened to 152.89 per dollar on Tuesday, its strongest level since mid-February, and is currently at 153.46. Gains have since narrowed. Behind the rally, traders continue to add to bets on Bank of Japan rate hikes and remain wary of further official action to support the yen.

The core logic of carry trades is to borrow in low-interest currencies and invest in high-yield assets to earn the interest rate differential. The yen has long been one of the main funding currencies for this strategy, so expectations of BOJ rate hikes pose potential pressure on the trade.

Funding Currency Diversification Makes Carry Trades More Flexible

Morgan Stanley strategists note that investors are actively diversifying their funding sources, with the euro and Swiss franc increasingly becoming alternative options for financing high-yield asset positions. This structural shift means carry trades are less sensitive to fluctuations in any single funding currency, enhancing the strategy's overall resilience.

Bloomberg previously reported that emerging-market carry trades recently posted their longest winning streak since 2008, with market participation remaining elevated.

The Morgan Stanley team maintains a positive view on emerging markets and recommends investors buy on dips. "Bottom-up fundamental support, attractive carry, and resilient global growth will continue to attract investors to the asset class," the strategists said.

The team stressed that the real threat to EM carry trades is a systemic shock that triggers broader market volatility, not the yen's periodic appreciation itself. With global growth expectations not yet showing clear deterioration, the strategy's underlying logic remains intact.