Carry Trade Revival in a Low-Volatility Rate Environment

The revival of carry trade strategies in a low-volatility interest rate environment has rekindled debates about their risks and rewards. From 2023 to early 2024, the strategy thrived on historically wide interest rate differentials and subdued market turbulence. A classic example is the USD/JPY carry trade, where borrowing in yen to invest in higher-yielding assets like the Mexican peso generated over 44% gains in a single year, according to a Reuters report. However, as central banks began to ease monetary policy in mid-2025, the profitability of such strategies has come under pressure. Projected returns for traditional USD/JPY positions have fallen from 4.25% to 3.75%, reflecting narrower spreads and heightened sensitivity to policy shifts, according to a UBS analysis.

Strategic Allocation to High-Yielding Currencies

In a stable rate environment, investors must balance the allure of high-yielding currencies with the need for risk mitigation. Emerging market (EM) investment-grade hard currency debt has emerged as a compelling alternative. This asset class combines attractive yields with improved credit fundamentals, including stronger sovereign ratings and disciplined fiscal policies in many EM economies, the UBS analysis notes. For instance, EM corporate and sovereign bonds have outperformed their U.S. counterparts in terms of credit quality while offering higher returns, making them a cornerstone for strategic allocation, the UBS analysis adds.

Diversification remains critical. In a world of shifting trade policies and inflationary pressures, low-correlation assets such as inflation-linked bonds, gold, and infrastructure equities can reduce portfolio volatility, according to an iShares report. Notably, EM hard currency debt has demonstrated resilience even during periods of tariff-related uncertainty, underscoring its role as a stabilizing force, as highlighted in the UBS analysis.

Hedging and Dynamic Risk Management

Static hedging approaches, which rely on rigid rules like full or no hedging, often lead to suboptimal outcomes. Instead, dynamic strategies that respond to market signals-such as carry, momentum, or purchasing power parity-offer superior risk-adjusted returns, the UBS analysis argues. For example, hedging EAFE equity exposure into U.S. dollars over the past decade has generated a tailwind due to favorable interest rate differentials, a point the iShares report emphasizes. However, in a stable rate environment, investors must carefully assess whether the carry justifies the volatility taken on. A risk-aversion-based model, which evaluates carry against expected volatility, provides a robust framework for hedging decisions, according to the UBS analysis.

Alternative Assets and Portfolio Resilience

Alternative strategies have gained prominence as tools for diversification. Bitcoin and gold, despite their volatility, offer minimal correlation with traditional assets. Gold's 10-year correlation with the S&P 500 stands at -0.01, while bitcoin's is 0.15, making them potential hedges against geopolitical risks, the UBS analysis observes. Meanwhile, funds like the BlackRock Global Equity Market Neutral Fund have delivered higher returns with lower risk compared to the Bloomberg US Aggregate Bond Index, highlighting the value of alternative allocations, the UBS analysis notes.

A new strategic framework introduced in 2025 emphasizes robust optimization, which accounts for uncertainty in expected returns and enhances diversification. This approach incorporates simulation engines to test portfolios under various scenarios, ensuring resilience in uncertain conditions, as described in the iShares report.

Conclusion

The carry trade's revival in a low-volatility environment hinges on disciplined strategic allocation and adaptive risk management. While high-yielding currencies and EM debt offer compelling returns, their integration into portfolios must be tempered with dynamic hedging and alternative assets to navigate evolving macroeconomic risks. As central banks continue to navigate the delicate balance between growth and inflation, investors who prioritize flexibility and diversification will be best positioned to capitalize on the opportunities ahead.