Citi Says Hedge Funds Are Using Dollars for New Carry Trades

Citigroup Inc. says the carry trade is back, but with a key difference: hedge funds are borrowing US dollars rather than the yen for their wagers on emerging markets.

Investors have ramped up bets for more than three quarter points of interest-rate cuts from the Federal Reserve this year. Combined with the Bank of Japan’s hike in July, that’s damaged the old model of wagering on robust US growth and rock-bottom Japanese borrowing costs.

“We’ve seen our positioning sentiment on the US dollar starting to turn much more bearish,” said Kristjan Kasikov, global head of FX quantitative investor solutions at Citigroup. “An environment where people are speculating about rate cuts has fueled risk appetite.”

That’s a turnaround since the global slump at the start of the month when carry trades were pummeled. In a carry trade, investors borrow in currencies where interest rates are low and park the proceeds in riskier assets where rates are high.

Now, hedge funds using the strategy are picking the dollar over the yen as the funding currency, given the prospect of diverging rates in the US and Japan, Kasikov said.

The greenback is trading at its lowest since March and hedge funds have been using it since Aug. 5 to buy emerging-market currencies, including the Brazilian real and Turkish lira, according to Kasikov.

In the first half of 2024, the dollar was climbing steadily as traders dialed back expectations that the Fed would aggressively ease rates. A Bloomberg gauge of the dollar rallied nearly 5% between January and June, while the yen fell to its lowest mark in nearly 40 years.