Currency Pegs and Carry Trades
Doug Nolan
Ten-year Treasury yields rose eight bps this week to 4.56%.
Yields rose to 4.60% intraday in Wednesday trading, the high since May 21st – and only seven bps below the May 19th peak closing high (4.67%).
It’s worth remembering that 10-year Treasury yields dropped to a February 27th low of 3.94%.
Five-year Treasury yields traded to 4.34% Wednesday (closed week at 4.30%) – the high back to February 2025.
Two-year Treasury yields traded to 4.23% intraday Wednesday, also the high since February 2025 (closed week at 4.21%).
Benchmark MBS yields rose to 5.56% Wednesday, the high since the May war spike (closed week 5.53%).
July 7 – Axios (Courtenay Brown and Neil Irwin):
“Financial markets increasingly have a new bet about the next phase of America’s economy: Inflation may be coming under control, but borrowing costs could stay higher for longer.
The de-escalation in the Iran war and the reopening of oil flows have caused a marked improvement in the near-term inflation outlook, but that hasn’t translated into cheaper overall borrowing costs.
Rather, bond prices are indicating higher real interest rates, counteracting the decline in market-based inflation expectations.
It means that the energy price retracement has brought little relief to rate-sensitive sectors.”
July 9 – Bloomberg (Elizabeth Stanton):
“An auction of 30-year Treasury bonds Thursday drew the highest yield in nearly 20 years…
The bonds were awarded at 5.058%.
While the auction result was the highest since 2007, it was lower than anticipated…”
The market is pricing a 4.10% policy rate for the April 28, 2027, FOMC meeting, implying almost two (1.9) rate increases.
This compares to 2.925% on February 27th.
So, the rates market has gone from two cuts to now pricing two rate increases.
Interestingly, the end of “Operation Epic Fury” and a $30 plus collapse in crude prices have had a negligible impact on market rate expectations.
It’s worth noting that the New York Fed’s June survey of Consumer Expectations had one-year inflation at 3.67% - the high since September 2023, with three-year inflation expectations at 3.3%, the high back to June 2022.
But this is not a domestic story.
Wednesday’s “Trump says Iran MOU ‘Is Over’” and the 6% spike in crude prices exposed ongoing global bond market fragility.
French yields spiked 14 bps Wednesday to 3.93% - the high back to June 2009.
French yields closed the week at 3.83%, up 61 bps from February 27th.
German 10-year yields spiked 12 bps intraday to 3.12% (closed 3.09%), trading within seven bps of the 14-year high from May 19th (3.19%).
UK yields jumped 13 bps intraday Wednesday to a six-week high of 4.98% - with the week’s 4.87% close 64 bps higher since the start of the war.
Italian yields spiked 14 bps intraday Wednesday to 3.91% - within 13 bps of March’s three-year high.
Greece yields jumped 13 bps Wednesday to 3.81% - within 18 bps of March’s multiyear high.
France’s 14-year-high yield is kid stuff.
July 7 – Financial Times (Ian Smith and Leo Lewis):
“Japan’s borrowing costs have shot to their highest in 30 years as investors fret over the tumbling yen and the effect of a $2tn long-term spending plan on the country’s massive debts.
A bruising sell-off in Japanese government bonds this year pushed the country’s benchmark 10-year yield to 2.87% on Wednesday, its highest since 1996.
Investors say the policies of Prime Minister Sanae Takaichi — centred on a $2.3tn spending plan spread over 14 years — are stoking the sell-off in long-term debt.
Some also worry that the Bank of Japan, which raised interest rates to 1% last month, will fall behind the curve and let inflation rise above its 2% target.”
Japan’s 10-year “JGB” yield rose to 2.90% intraday Thursday (at that point up 12 bps w-t-d), blowing through May’s spike high (2.78%) to the highest yield since September 1996.
Bloomberg noted the 10-year yield posted “its ninth straight day of gains, the longest streak in 19 years.”
The dollar/yen traded to 162.71 in Wednesday trading, near the weakest level versus the dollar back to 1986.
This is how crises erupt.
July 10 – Bloomberg (Erica Yokoyama):
“Japan’s finance minister called for the nation’s massive pension funds to increase investments in domestic assets, boosting the yen from near four-decade lows and spurring a rally in bonds.
‘One priority is to encourage households, as well as pension funds including the GPIF, to increase their investment in Japanese financial assets.
We intend to pursue policies that support that objective,’ Finance Minister Satsuki Katayama said…, referring to the Government Pension Investment Fund.
It’s one of the world’s largest pensions with ¥293.6 trillion ($1.81 trillion) in assets.”
The yen rallied 0.7% on Katayama’s timely comment, ending Friday’s session with a meager 0.43% gain (down 0.21% on the week).
The bond market reaction was more dramatic.
Ten-year JGB yields sank 13 bps to 2.72%.
There were years when JGB yields barely moved 13 bps.
The odds are decent that Japan, France and UK markets are leading an upside breakout for global bond yields more generally.
In such a heavily indebted world with highly levered global bond markets, one would typically expect some fraying nerves to make their way into higher risk premiums and CDS (Credit default swap) prices.
Not so much, at least so far.
The VIX (equities volatility) Index closed the week at 15.03, the lowest close since the first week of the year.
While the MOVE (bond volatility) Index posted a one-month high (72.41) on Wednesday, Friday’s close (69.55) was just a few points from lows back to the onset of the war.
The MOVE spiked to 115 in late March.
High yield spreads and CDS prices are not far from multiyear lows.
Bottom line: financial conditions remain exceptionally loose.
July 10 – Bloomberg Intelligence (Brian Meehan):
“US credit markets are priced for perfection.
Heavy issuance… continues to be met with robust demand, keeping investment-grade and high-yield spreads near record tights.
At the same time, credit volatility sits near decade lows while put buying, open interest and downside skew in LQD and HYG continue to fade, signaling growing investor complacency.
Together, tight spreads, subdued volatility and collapsing demand for downside protection leave credit with little margin for error should the AI capex, supply or macro narrative begin to crack…
Combined investment-grade and high-yield issuance reached $240 billion in June, the second-heaviest June on record, while investment-grade issuance alone set a June record at $204 billion.
Year-to-date issuance has climbed to $1.4 trillion, trailing only the pandemic-driven surge of 2020…
The biggest driver remains hyperscaler-led AI spending…
Record issuance. Record-tight spreads.
Decade-low volatility.
Vanishing demand for hedges already near record lows.
Any one could be dismissed.
Together, they describe a credit market priced for perfection.”
There is understandable amazement (exuberance) that nothing has stymied Teflon Markets – tariffs and trade wars, inflation scares, geopolitical instability, military wars, Trump and Fed issues, and such.
The key analytical issue is not so much market complacency, as it is the persistence of loose financial conditions.
It is this extraordinary resilience of loose financial conditions worthy of deep contemplation.
Between March 2022 and July 2023, the Fed hiked rates from near zero to 5.25 to 5.50%.
However, an extraordinarily aggressive “tightening cycle” failed to meaningfully tighten financial conditions.
The growth in Non-Financial Debt (NFD) slowed marginally from 2022’s (highly elevated) $3.738 TN to $3.617 TN in 2023 and $3.500 TN in 2024 – only to surge to $3.965 TN last year (surely supported by Fed rate cuts).
Equities prices continued to inflate throughout the “tightening,” especially technology stocks.
From March 16, 2022 (first hike) to July 26, 2023 (final hike), the MAG7 Index rose 24.9%.
The steadfastness of Credit growth and loose financial conditions is not a conundrum.
For starters, annual Treasury borrowings exceeded $2 TN in 2023, 2024 and 2025 – providing powerful Credit system and economy ballast.
Meanwhile, an enterprising Wall Street was working overtime: “private Credit” and leveraged lending; “repo,” hedge fund “basis trades” and “carry trades,” speculative leverage and derivatives…
Over three years (’23 through ’25) Broker/Dealer balance sheets expanded $1.902 TN, or 44%, as money market fund assets (MMFA) inflated an incredible $2.967 TN, or 57%.
Hedge fund “repo” borrowings ballooned $2.152 TN, or 175%, to $3.379 TN.
At this point in the cycle, prospects for a couple rate increases and some back up in global yields will not conjure fears of market upheaval.
Conditioned by years of success, an overconfident Wall Street today sees opportunities in about whatever scenario the markets might follow.
July 9 – Bloomberg (Ruth Carson and Masaki Kondo):
“Carry trades — one of the most widely-used strategies in the $9.5 trillion-per-day currency market — are seeing the most compelling backdrop in more than two decades, according to Goldman Sachs...
Betting on carry bears more relevance in the Group of 10 foreign-exchange space than at almost any point since 2000, strategist Stuart Jenkins wrote...
Goldman currently favors funding the trades using the yen, Swiss franc or euro in the months ahead, he said, referring to the technique of borrowing in a relatively low-yielding currency and investing in one where they are higher.
Several factors have catapulted the trade’s appeal. Goldman said interest rates across the world’s biggest developed economies have settled at high and varied levels, creating unusually wide yield gaps for investors, while currency volatility has dropped to historically subdued levels…
That combination has helped G10 FX carry trades return about 8% this year, beating global bonds, gold and Bitcoin…”
July 5 – Bloomberg (Vinicius Andrade and Maria Elena Vizcaino):
“Emerging-market traders are increasingly turning to currencies from the euro to the Australian dollar to fund bets in the developing world as the US dollar roars back.
Money managers from Invesco Ltd. to AllianceBernstein are among those who say they’re relying less on the dollar to fund positions in higher-yielding currencies.
Morgan Stanley told clients to express optimism on developing names against a broader basket comprising not only the dollar, but also the euro and yen.
And Citigroup Inc. recently recommended betting that the Brazilian real will strengthen against the euro and the Australian dollar.”
July 9 – Bloomberg (Carter Johnson):
“Carry trades are likely to remain in favor this year as a durable global economy leaves yield the defining force in foreign-exchange markets, outweighing shocks like the Middle East conflict and leadership change at the Federal Reserve, according to Deutsche Bank AG.
‘One thing has driven FX markets this year: yield,’ George Saravelos, head of currency strategy at Deutsche Bank, wrote...
‘Despite a major war in the Middle East, leadership change at the Fed, and massive shifts in tech valuations, the most important driver of 2026 currency moves has been risk-adjusted carry.’”
Yen weakness has provided powerful tailwinds to global “carry trade” returns.
Euro weakness (and low policy rates) has also offered favorable funding.
Traders seem confident this bonanza can continue indefinitely with timely rotations and policymaker responses.
No one knows the scope of global “carry trade” leverage.
I assume it has ballooned into the many trillions.
No one wants to venture a guess, at least publicly.
“Carry trade” leveraging is integral to what has evolved into uniquely synchronized loose global financial conditions across markets and economies.
Expanding speculative leverage continues to generate liquidity abundance virtually everywhere.
And these loose conditions remain self-reinforcing.
Loose finance spurs debt issuance, rising market and asset prices, compressed risk premiums - and then only more risk-taking, speculative leveraging and looser conditions.
Importantly, the global government finance Bubble is in the throes of historic “terminal phase excess” – with leveraging in perceived safe and liquid government securities at its epicenter.
Moreover, today’s loose global financial conditions mask myriad festering serious issues and mounting systemic fragilities.
July 8 – Financial Times (Song Jung-a):
“As South Korea is on track to have the world’s best-performing major stock index for a second year, its ambition to be recognised as a developed market is being held back by the scars of a crisis from three decades ago.
A blistering rally driven by AI chip suppliers Samsung Electronics and SK Hynix has helped the Kospi triple in value since the start of 2025…
‘The government is still haunted by the ‘IMF trauma’ and is afraid that foreign influence over the forex market will become bigger once they allow offshore trading of the Korean won,’ said Hwang Seiwoon, a researcher at the Korea Capital Market Institute.
During the 1997 Asian financial crisis, the won lost about half its value in two months, while the country’s foreign reserves fell to a low equivalent to just four or five days of imports.
The turmoil pushed South Korea to the brink of default, driving up short-term debt and triggering a wave of corporate bankruptcies.
Seoul was forced to seek a bailout from the IMF.”
It’s difficult to believe next year will mark the 30-year anniversary of the “Asian Tiger Bubble” collapse.
What began on July 2, 1997, with Thailand abandoning the baht’s dollar peg, spread like wildfire.
Contagion swiftly saw “hot money” exodus from the Philippine peso, Malaysian ringgit, and Indonesian rupiah, with devastatingly synchronized currency and bond market collapses.
Hong Kong and South Korea succumbed somewhat later in the year.
Destabilizing inflation, economic collapse, mass unemployment, and even riots and social upheaval.
Having closely monitored the speculative excesses - including hedge fund and derivatives-related leveraging - throughout the Bubble period, it was especially disheartening to watch the devastating collapse.
But I did think at the time that global policymakers had at least come to understand the dangers of destabilizing “contemporary finance” and Bubbles.
Nope.
Pegged currencies were that period’s weak link.
Not only did they foster speculative leveraging, currency pegs also ensured self-reinforcing “hot money” flows, resulting in mounting financial and economic fragility.
Loose conditions stoked the boom, while masking epic systemic maladjustment.
The breaking of the Thai baht peg set off a chain reaction of broken pegs, deleveraging, bond and currency market mayhem, the seizing up of Credit systems, economic collapse, and social upheaval.
IMF bailouts provided some stabilization.
New financial structures arose from the ashes.
Currency peg regimes were shunned, while Asian economies built large dollar reserves to protect against abrupt “hot money” outflows.
It took years and a lot of hard work, but these countries recovered.
I fear the current “carry trade” regime shares key similarities to nineties currency pegs.
Years of seeming stability and surefire speculative returns have fostered massive self-reinforcing “hot money” speculative leveraging/flows.
Speculative leverage has accumulated over years, across markets and economies.
“Basis” and “carry” trades everywhere, with a few recent years of “blow off” excess.
More recently, the global AI arms race has taken “terminal phase excess” to perilous extremes.
Along with massive speculative leverage throughout government debt markets, one can now add huge AI-related debt issuance and stock market speculative leveraging (i.e. margin debt, leveraged ETFs, derivatives…).
I won’t venture a guess as to what initially upsets the apple cart.
It could be debt market dislocation in any number of countries.
An acute geopolitical crisis.
There could be a run on a particular currency, or dislocation in a major funding currency (such as the yen).
Or perhaps the trigger will simply be a bursting stock market Bubble (i.e., led by South Korean memory stocks).
I am comfortable predicting powerful contagion effects – a likely chain reaction of de-risking/deleveraging that will reverberate across global markets.
There should be no doubt that Bubble dynamics function poorly (being kind) in reverse.
I can’t help but think that global bond markets are sending a warning.
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