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The dollar-carry trade supports US dollar
- For much of 2025, the value of the US dollar declined against major currencies. In part, this reflected investor unease about the unpredictability of US trade policy. In part, it might have reflected an expectation of diminished US military support for its allies. And partly, it reflected the expectation that the US Federal Reserve may ease monetary policy while other central banks remain cautious. Yet, in recent months, the dollar has rebounded modestly. This is likely due to the so-called “dollar-carry trade.” Let me explain.
US equities have performed exceptionally well this year, and foreign investors have been eager to purchase them, hoping to enjoy strong returns. To manage potential currency risk, many foreign investors hedged against the risk of dollar depreciation by purchasing futures contracts.
However, some foreign investors have lately borrowed at a lower cost in foreign currencies such as the Japanese yen or the Swiss franc, converted these currencies to US dollars, and purchased US equities. Their hope has been that the return on US equities will more than offset any potential dollar depreciation. In the end, they convert to yen or francs and pay off their cheap loans. This activity has contributed to upward pressure on the dollar, thereby contributing to its recent appreciation.
This strategy remains viable as long as market conditions hold; that is, there are potential events that could undermine the return on this strategy. For example, a sharp correction in AI-related equities could reduce returns significantly. In addition, if the US Fed eases US monetary policy faster than is now expected, it could put downward pressure on the value of the dollar, especially if other central banks maintain their stance. Additionally, if the Bank of Japan renews its earlier path of interest-rate increases, the yen could strengthen, thus reducing the appeal of the dollar-carry trade.
In any event, the existence of the dollar-carry trade suggests that the dollar’s global role remains substantial. The depreciation seen in 2024 led some observers to speculate that the dominant role of the dollar could be declining, especially as China’s government takes new steps to boost the attractiveness of holding Chinese renminbi. The strength of the dollar-carry trade has been based mainly on the strength of the US equity markets, largely driven by optimism around artificial intelligence investments. Thus, it appears that US leadership in emerging technologies is driving renewed interest in US currency.
Moreover, the narrative around de-dollarization in global financial markets appears to be overstated. After all, the dollar remains, by far, the most important currency for trade, central bank reserves, and asset holdings. Plus, there are few viable alternatives. Even though China wants more use of the renminbi, the existence of capital controls in China creates constraints of holding renminbi, thereby limiting its global role. The only other major currency is the euro. In this case, the lack of financial and fiscal integration means that there is not a large, liquid market for euro-denominated government debt. As such, the euro faces difficulty competing with the US dollar. Therefore, even if dollar depreciation resumes, and even if global investors seek to diversify away from US dollars, it seems that its central role will likely continue for the foreseeable future.
On the other hand, perhaps a notable trend in global finance lately has been the relative attractiveness of assets denominated in emerging market (EM) currencies or issued by EM governments. Traditionally, EM debt has been traded at a discount relative to US government debt, largely due to the perceived risk of default. EMs are often seen as relatively unstable, due to perceived default risk and vulnerability to shocks—especially if they are commodity exporters. Advanced economies, on the other hand, were traditionally seen as more stable, fiscally disciplined, and better able to absorb shocks.
This perception has shifted, however. First with the global financial crisis, and then with the pandemic, advanced-economy governments took on lots of debt. Today, the United States, Japan, and many Western European governments now have historically high debt-to-GDP ratios. Moreover, many of these governments suffer from political gridlock and demographic pressures that add to fiscal challenges. Meanwhile, many (but not all) EMs have strengthened fundamentals. Many have tightened fiscal policy, given their central banks independence, liberalized trade and cross-border investment, and encouraged economic diversification.
One result is that the average EM has a much lower debt-to-GDP ratio than the average advanced economy. Consequently, the yield premium on EM debt has narrowed, although it remains; and the fact that it remains suggests an opportunity for investors. If they believe that EM probity will remain, then they might anticipate further relative appreciation of EM debt and EM currencies. Plus, increasing attractiveness of EM debt and other assets could serve these countries well, enabling them to attract capital at a low cost, thereby fueling increased investment that contributes to economic growth.