EM Carry Trade Attractiveness: Navigating Volatility Compression and Central Bank Policy Shifts

Emerging market (EM) equities have defied conventional wisdom in 2025, surging 15.6% in the first half of the year and outperforming the S&P 500 by a wide marginTurning Tides: EM Equities Are Surging in 2025^[2]. This resilience, coupled with narrowing volatility and shifting central bank policies, has reignited interest in EM carry trades—a strategy that profits from borrowing low-yielding currencies to fund higher-yielding assets. However, the landscape is evolving rapidly, with structural changes in EM policy frameworks and divergent global monetary conditions reshaping risk-return profiles.

Volatility Compression: A New Normal for EM Markets

Emerging markets have demonstrated a remarkable ability to insulate themselves from global interest rate volatility, a trend that has compressed risk premiums. According to the IMF, EM central banks in Latin America and Asia have become less responsive to U.S. rate changes due to stronger policy frameworks, including inflation targeting and flexible exchange ratesEmerging Markets Navigate Global Interest Rate Volatility^[1]. This resilience is evident in Q2 2025, where the MSCI Emerging Markets Index rose 12.7%, driven by stabilization in China, India, and BrazilEmerging Markets Navigate Global Interest Rate Volatility^[1].

The compression of volatility is further supported by improved macroeconomic buffers, such as higher foreign exchange reserves and more disciplined fiscal policies. For instance, Brazil's MSCI index surged 13.3% in Q2 2025, fueled by easing inflation and fiscal reformsEmerging Markets Navigate Global Interest Rate Volatility^[1]. Meanwhile, India's 9.2% gain reflected unexpected monetary easing and robust domestic demandEmerging Markets Navigate Global Interest Rate Volatility^[1]. These trends suggest that EM markets are no longer as susceptible to sudden capital outflows as in past crises, such as the 2013 taper tantrum.

Central Bank Policy Shifts: Divergence and Neutral Rates

Central bank policies in 2025 are reshaping the carry trade landscape. The U.S. Federal Reserve and European Central Bank (ECB) have moved toward neutral interest rates—neither stimulating nor tightening aggressively—to balance growth and inflationMonetary Policy Shifts in 2025: What’s Next for Central Banks^[3]. The Fed's target range of 2.75%-3.25% and the ECB's 2% deposit rate have narrowed the interest rate differentials that traditionally underpinned carry tradesMonetary Policy Shifts in 2025: What’s Next for Central Banks^[3]. This shift reduces the appeal of high-yield currencies like the U.S. dollar and euro, which were once staples of the strategy.

Meanwhile, divergent policies among major central banks are creating asymmetries. The Bank of Japan (BOJ) has exited negative rates, raising short-term rates to +0.5% in Q3 2025Emerging Markets Navigate Global Interest Rate Volatility^[1]. This move has diminished the yen's role as a traditional funding currency, with some analysts even suggesting long positions in JPY as rate differentials narrowEmerging Markets Navigate Global Interest Rate Volatility^[1]. Conversely, the Swiss Franc (CHF) remains a concern for carry traders due to medium-term bullish risks, such as potential rate hikes from the Swiss National BankEmerging Markets Navigate Global Interest Rate Volatility^[1].

The Bank of England (BoE) and ECB are also navigating complex trade-offs. The BoE is cautiously lowering rates while monitoring persistent inflation, while the ECB has paused its rate-cutting cycle amid uncertainties in EU–U.S. trade negotiationsEmerging Markets Navigate Global Interest Rate Volatility^[1]. These divergences amplify volatility in swap spreads and forward rates, complicating carry trade executionMonetary Policy Shifts in 2025: What’s Next for Central Banks^[3].

Carry Trade Attractiveness: A Reassessment

The narrowing of interest rate differentials and the transition to neutral rates have forced investors to reassess carry trade strategies. J.P. Morgan notes that returns on carry trades are expected to diminish as high-yield central banks begin cutting ratesTurning Tides: EM Equities Are Surging in 2025^[2]. For example, the Chinese yuan (CNH) has emerged as a relatively attractive funding currency due to its structural bearish risks and lower volatility compared to the yen or Swiss francEmerging Markets Navigate Global Interest Rate Volatility^[1].

However, global economic challenges, such as deflationary pressures in Europe and regional conflicts, add uncertainty. European central banks are implementing targeted lending programs to stimulate growth, further complicating the coordination of global monetary policyMonetary Policy Shifts in 2025: What’s Next for Central Banks^[3]. These dynamics suggest that carry trade investors must prioritize currencies with strong fundamentals and credible policy frameworks, while avoiding frontier economies with limited access to external financingEmerging Markets Navigate Global Interest Rate Volatility^[1].

Conclusion: A Cautious Outlook for EM Carry Trades

The 2025 surge in EM equities and compressed volatility have created a favorable backdrop for carry trades, but structural shifts in central bank policies are tempering enthusiasm. While EM markets have proven more resilient to global shocks, the narrowing of interest rate differentials and the transition to neutral rates are reducing traditional arbitrage opportunities. Investors should focus on currencies with robust macroeconomic buffers, such as the CNH, while remaining vigilant about geopolitical risks and policy divergences.

As the global economy navigates a delicate balance between growth and stability, EM carry trades will require a nuanced approach—leveraging improved EM fundamentals while hedging against the uncertainties of a fragmented monetary policy landscape.