Macro Freestyle – The risk of a carry trade unwind
The desk is highlighting the increasing risk of a carry trade unwind, particularly in light of geopolitical tensions and diverging inflation trends between the US and China. Per the full note from Standard Chartered, the potential for heightened market volatility is significant, especially as investors reassess their positions in emerging markets (EM) amidst these uncertainties. The commentary underscores the importance of monitoring key developments that could trigger a broader reversal in global positions. As we approach critical economic indicators, the implications for currency pairs could be substantial.
What the desk is arguing
The desk frames this as a critical juncture for carry trades, emphasizing the potential for a swift unwind as geopolitical instability and fiscal sustainability risks mount. Standard Chartered's Eric Robertsen and Madhur Jha specifically note that the divergence in inflation rates between the US and China could exacerbate market volatility, creating a challenging environment for investors.
Supporting this view, the commentary highlights that a reversal in global positions could significantly impact EM economic resilience, suggesting that traders should be vigilant about shifts in market sentiment. The risk of a carry trade unwind is underscored by the current positioning of investors, which may be overly optimistic given the prevailing geopolitical landscape.
Where it sits in our coverage
Our consensus target for the EUR/USD is 1.075, with a range from 1.04 to 1.12. Notable targets from other firms include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
This view aligns closely with jpmorgan, which shares a similar outlook on the potential for volatility, while bofa presents a more cautious stance at the lower end of the range. The desk's target sits comfortably within the consensus spread, indicating a balanced perspective on the risks ahead.
How other firms see it
Several firms, including jpmorgan and citi, are aligned with the desk's view, emphasizing the risks associated with carry trades and the potential for market corrections. Conversely, bofa takes a more conservative approach, suggesting that the current market dynamics may not support aggressive positioning in carry trades.
Traders should also keep an eye on the USD/JPY trajectory, as movements in this pair could reflect broader market sentiment and central bank policies, particularly in relation to the Bank of Japan's stance on monetary easing.
What the calendar says
With no upcoming events scheduled, traders should remain alert to any unexpected geopolitical developments or economic data releases that could influence market sentiment and trigger a shift in positioning.
stanchart
Hello, I'm Eric Robertson, Global Head of Research and Chief Strategist at Standard Chartered. And I'm Madhur Jha, Global Economist and Head of Thematic Research also here at Standard Chartered. Welcome to Macro Freestyle, our monthly podcast series where Madhur and I will identify and explore topics that are likely to be most impactful and relevant for financial markets and the global economy.
Hello, everyone. I hope the new year has started on a very positive note for all of our listeners. We are recording this podcast on the 27th of Jan, 2026.
And today we will focus amongst other things on how investors should prepare for a possible unwind of the carry trade. So, Eric, it has been anything but a quiet start to 2026, especially on the geopolitical front. How should our listeners be thinking about the recent geopolitical events, including Greenland and threat of tariffs, Venezuela, or even the possible escalation of tensions in the Middle East?
Thanks, Madhur. It's great to be back on the Macro Freestyle podcast. We wrote at the end of last year that we thought that there would be a pickup in market volatility in 2026 for a variety of reasons.
But I have to admit that I did not anticipate this kind of geopolitical and political uncertainty that we've seen in the first weeks of the year. As you correctly point out, we have seen geopolitical uncertainty or tension pickup in Latin America, the North Atlantic and the Middle East, all in a very short period of time. And that has probably discouraged some investors and allocators of capital from fully engaging with the markets so far this year.
But the other thing it has done is it has masked or distracted people from some very important moves in some of the different markets. We've had volatility in the Japanese bond market, which is something that we had talked about late last year. We've seen some volatility in dollar yen in the foreign exchange market.
And probably most importantly, we've seen incredible volatility in some of the commodity markets. Now, all of this volatility has yet to really dent investor sentiment or risk appetite. But I suppose the way I would frame the discussion for today and also just for listeners going forward is that I think we need to expect an increased frequency of these volatility shocks going forward.
Now, what's interesting is so far, and I think we should underline so far, these individual volatility shocks have not really led to a more sustained or pervasive VAR shock, which is a forced liquidation of positions. And I'm not predicting or suggesting that we will, but I think history shows that when you get this series of volatility shocks, ultimately it starts to weigh on market sentiment. And if we start to see economic uncertainty combined with the geopolitical uncertainty that we've already discussed, I think that should make us all take a step back and say the risk environment has changed for 2026.
And, you know, one of the themes that we saw last year, which was quite reassuring, was the resilience of the EM economies, despite all the uncertainty. What explains that in your view? And are you worried, as you mentioned about the recent backup in JGB yields?
Is that one of the factors that could undermine that resilience or are there other things that you're thinking about? Considering all of the uncertainty in the world last year and even into the early part of this year, emerging markets and economies seem to be holding up relatively well. Now, part of that is the high yields on offer in places like Latin America.
Some of that is an extraordinary amount of central bank easing that we saw last year, which is still in place. There are a number of factors which have contributed to this. If I had to summarize it in one word, I would say liquidity.
We have seen a significant increase in liquidity globally over the last, let's call it 18 to 24 months. That is always going to be supportive of higher yielding emerging market assets. But we've also seen a couple of more traditional economic factors come into play.
The front loading of exports was a big factor last year that was supportive for trade linked economies. The other factor is that we've seen a significant redirection of trade corridors. And obviously, some of that is in response to Trump's tariffs and the uncertainty that that has created.
But I think what it highlights is something that you and I and the team have written about for a couple of years now, which is we have seen the emergence of new trade corridors. And these new trade corridors are proving to be significant contributors to both trade growth, but also to economic growth in places like the Middle East, Southeast Asia, etc. So, on an economic angle, I would say that as long as these emerging trade corridors continue to grow and continue to thrive, that should help to mitigate some of the economic uncertainty.
On the market side, I have written that I'm very concerned about bond market volatility this year. The shift to fiscal stimulus and the borrowing that that may entail, I worry that the JGB volatility shock that we've seen over the last couple of weeks is an early warning signal for what could be in store for bond markets over the course of 2026. And I guess that brings me to my first question for you, which is, let's talk a little bit more about this transition from monetary easing in 2025 to perhaps a greater focus on fiscal in 2026.
Now, government-directed stimulus can be a very good thing, but I think there's also quite a few risks related to that, and I wondered if you could expand on that a little bit. I think it's important to note that monetary policy has been doing most of the heavy liftings to support growth over the last two years, and now we're coming to an end of that cycle. Now, the focus obviously naturally pivots towards fiscal policy, but fiscal policy is only effective to the extent that it raises the productive potential of the economy on a more medium-term basis, rather than just having short-term populist support measures.
Given election cycles, the biggest risk that fiscal policy poses in key economies is that policies are actually exacerbating concerns about fiscal sustainability in the long run, or they raise inflation expectations, rather than leading to a market repricing of the growth outlook higher. And obviously, if you had a steeper yield curve or longer-term bond yields going higher because growth expectations are improving, then most countries can deal with that. But if you have a steeper yield curve because risk premium is rising or because inflation expectations are being repriced higher, then clearly that's going to have negative consequences.
So for the US, we expect a steeper yield curve that has implications for emerging markets. Emerging markets have had a spectacular year last year because of the global liquidity conditions that you've mentioned. But this year, we're looking at higher funding costs for these economies.
And clearly, if that's because of steeper yield curves led by risk premium, that's not a very good story. So then the focus will turn on, can these economies fund themselves domestically? Now, a lot of these countries have very limited fiscal space.
The ones which have almost no fiscal space are already in IMF programs and have embarked on key structural reforms. But there are some which have limited fiscal space. And I think the focus will be on those economies because what are the kind of fiscal policies that they pursue?
Is it infrastructure enhancing, productivity enhancing, or are they populist measures because of election cycles? So that will be the key risk that we have to watch out for in the coming months. Eric, what are some of the themes that you see playing out in global markets and how should our listeners interpret these narratives?
Look, a couple of themes have come back front and center, the first of which is concerns around U.S. policy credibility, policy predictability. And that encompasses both the political and geopolitical, but also even domestically with monetary policy. I think what is interesting is that we seem to have come back to the selling of the dollar as a response to some of this policy uncertainty.
And to us, that's very interesting because the market has priced out some of the Fed rate cuts that were expected for the year. So that should have been dollar supportive. We have seen, I think, a mixed U.S. economic data.
I think the story looks a little bit better than people had feared last year. And yet these positive factors are not getting any credibility or attention from the FX markets. The markets are leaning very much in the opposite direction.
The other narrative, which I think is super interesting, is that a lot of the fiscal concerns that you were just talking about seem to be an area of focus in developed markets. The U.S., Japan, U.K., Europe. It does not appear to be something that investors are worried about from an EM point of view, which I think is a really interesting role reversal, if you will.
The shift of capital into emerging economies, whether it's equities, currencies, etc., continues the trend from last year. And that suggests that people are reasonably comfortable with the fiscal outlooks for a number of these economies, the ones that are obviously not in IMF programs, as you mentioned. So I think there are some aspects of what we're seeing so far this year that suggest further diversification away from the U.S. and into emerging economies.
Now, the next interesting topic that I would flag to people is that we have seen significant volatility in a handful of places that doesn't seem to be having any notable impact on risk sentiment. Commodities is one. Natural gas is up something like 60% already a year to date.
Silver is having another spectacular rally to new record highs. Gold participating as well. We're seeing really violent moves in the commodity space, and it's having no impact on risk appetite, risk sentiment, etc.
So that will be another theme to keep an eye out for. The final point I would make is we do have the U.S. midterm elections coming up in November. And I think we have to keep that in mind as we try to anticipate the U.S. policy trajectory, both economically and politically, over the next six months.
So for me, that's going to remain a key theme in the background. Madhur, you mentioned a few minutes ago this idea of the productivity story, and I think you were referring to the U.S. The team has written about the productivity improvement in the U.S.
Certainly, the FX markets don't seem to care about that at the moment. But I wondered if you could expand on that for the rest of the global economy. Clearly, I think we have to preface all of the discussion by saying that it's very, very hard to measure productivity growth, especially total factor productivity growth, which really does tell you about the real productive potential of the economy.
There are several issues with measuring productivity. However, it is clear that TFP growth was weakening in the decade leading up to the COVID crisis on a global basis, both emerging markets and the Western world. Since then, however, we have seen TFP growth starting to pick back up, and we have written about how the U.S. might be seeing a structural improvement in productivity.
While the U.S. is the leader, and some of it might be related to AI, but it's not just the AI story. This is better management practices, efficiency gains that are being made. We are also seeing similar productivity gains in China, and I think that's really been the leader in terms of improving its productive potential.
We see TFP growth actually adding something like 0.3 percentage points to GDP growth for China over the coming years. And this is related partly to the focus on technology and AI, upgrading of skills, becoming more efficient, but also partly to the reallocation of resources away from the real estate sector to faster growing, more efficient use of resources in the new economy sectors. Whether it's EV or technology, renewable energy, all of this is leading to an improvement in productivity.
We're also seeing improvements in infrastructure spending and in the building up of technology in countries like India and Philippines and Malaysia, where they're trying to focus on data centers and improve their services sector. So there is a move happening in trying to capture some of these gains of productivity. And I think that's quite a positive narrative over the more medium term.
Of course, we have to continue to see focus on structural reforms in most of these emerging markets. But I think this is a very positive trend that will start to have an impact on the growth and inflation narrative as we go ahead. One of the things that I always find difficult about the productivity discussion is we know it's a good thing when we see it and we know it's going to be a good thing for the economy, but it's not tangible.
Whereas inflation, whether it's going up or going down, is tangible for consumers, it's tangible for policymakers. And when it's going in the right direction, i.e. less positive, that's a good thing. Cost of living is improving for consumers.
And I wondered if you could talk a little bit about the divergence of inflation between the U.S. and the rest of the world. Because it appears to me that the cost of living challenge in the United States is not getting any better. I mean, CPI and core PCE are relatively well behaved, but they're not back at the Fed's target.
They're still well above it. And I just wondered if there's this light bulb moment coming for the U.S. economy or even for the global economy where we say the productivity miracle will get inflation to come down or if that will always remain a disconnect. I wonder if you could highlight that a little bit.
I think that's a great point that you've made. Of course, productivity should ultimately lower inflation to some extent because it's improving your efficiency. That would be a virtuous cycle, but it takes time.
There is a period of disruption in between. And I think the biggest issue that we face at this point of time is that it's not just a productivity story in the U.S. There's also a tariff and geopolitics story in the U.S., which is in some ways impinging on any of the positive benefits that you can get from the productivity story.
Here, the data that we have so far seems to suggest that the tariffs are inflationary. This is very preliminary data, of course. Historically, tariffs are usually borne by the exporter.
But during these tariff wars and even the previous one during Trump's first administration, tariffs have been borne by the U.S. importer by and large. 85 to 90 percent of tariffs are being absorbed by U.S. importers who are now slowly beginning to pass that on to the U.S. consumer. Now, this is obviously leading to a rising goods inflation. And as you very correctly mentioned, there is a cost of living crisis because there is evidence that there is cheap inflation happening.
So the cost of cheap imports is rising much faster than the cost of luxury imports. And that's leading to a much worse outcome for the lower income sections of the U.S. economy. I think what's interesting to me also is that the U.S. faces more tariff inflation than in the past because tariffs usually are seen to be potentially disinflationary because they act as a demand shock.
However, the demand shock channel works through wealth effects such as lower stock market prices, higher stock price volatility. None of that is happening at this point of time. Stock markets continue to do well.
And so that negative wealth effect is not really in place. So you're not getting the disinflationary impact of that. So overall, we are seeing tariffs being more of a source of inflation in the U.S. economy.
For the rest of the world, I think the picture is a little bit more benign. China continues to exert disinflationary pressure given its PPI deflation in particular. And we continue to see concerns about excess capacity, weak consumer demand, negative wealth effects.
From the real estate sector in China continuing to play a role over the next year or so and keeping the deflation story in play. And that will obviously continue to have an impact for the rest of the world. So clearly, we think that in the short run, you are seeing a divergence in the inflation trends between the U.S. and China.
But Eric, actually recently, there's been a lot of interest in a potential reflation story in China. Do you see this as possible in 2026 itself? What do you think would trigger it?
And could fiscal policy be the main driver of such a reflation story? My base case is I still think it's premature to talk about reflation in China. And there's a couple of reasons for that.
The first is that I still see the consumer in China being significantly impaired. The real estate market has not turned around. The labor market has not turned around.
Wage inflation is still benign, which is a polite way of saying wages are going down. Interest rates are still very low. Yes, the equity markets have improved, but that's really only beneficial for a small segment of the population.
For me, the critical story is that not only is the consumer struggling to turn around their risk appetite and animal spirits, but I also see relatively little evidence that the government is getting closer to a more forceful or more pronounced fiscal stimulus. For the most part, it appears to be a drip feed approach to tweaking policy measures here and there, whether it's lowering certain lending rates or changing subsidies for consumer trade in programs. But I don't see Big Bang or more forceful effort to stimulate the private sector.
And I think that's really one of the missing links. I mean, consumer spending as a percentage of GDP is still extremely low in China. We know they have talked about lifting that as well as lifting the services side of the economy.
But consumers are still very risk averse. Auto sales are starting to turn down in China, which is a little bit of a source of concern because that's been a very powerful story. And fixed asset investment is now struggling.
And so we have a handful of factors that at a minimum measure have not stabilized. They're still under some downward pressure. And I would like to see signs of stability first before I got excited about a reflation story.
Now, I think there is the potential for that fiscal stimulus to come. We thought it might come last year, but the benefit of their export strength last year meant that they didn't need to add fiscal stimulus. But if you were to see exports out of China lose some momentum this year, they would have to find some other sources of growth.
And that might require adding some more fiscal support to the consumer side of the economy. Sure, Eric. And maybe a last question from me.
In your latest report, you have talked about the possibility of an unwind of the carry trade. What asset classes can investors look at more favorably in such a scenario and how should they prepare for such an unwind? Sure.
Look, the reason I've talked about this is an extension of the concerns that we have about bond market volatility. The carry trade is always a function of two things. It's the asset side and how much yield you can get, but it's also the funding side or the liability side, how much it costs you to have that position on.
And if funding costs go higher or if bond market yields go higher and with higher volatility, the term premia effect that you mentioned earlier, it makes carry trades a lot more difficult to hold. The volatility adjusted expected return deteriorates. And that is a risk that I think is really important to be aware of for 2026 because there's been so much capital that's gone into EM over the last year.
So I do think the bond market as a source of volatility for carry trades is really something we need to pay very, very close attention to. Now, the other point that's worth mentioning is we talked earlier about the fact that the fiscal concerns so far this year have largely been devoted to DM. EM, I think, would really start to struggle from both an economic and the financial market point of view if you started to see a more wholesale unwind of carry trades.
And I think that would be really, really counterproductive for this growth recovery, the reform story, et cetera, for EM. So it has multiple implications. The final question is, where should you be hiding?
Where are the safe havens? The nature of safe havens has changed. Gold has already rallied dramatically.
Some of the other assets, I think, have liquidity question marks around them. Maybe they're not as liquid as people need them to be. U.S.
Treasuries are being reevaluated as a safe haven. I still think they're viable. But if people decide that there's too much fiscal risk or political risk, maybe that changes.
So I think we need to be very conscious about what bond market volatility means for all asset classes in 2026 because that, to me, would be the real banana skin, so to speak. Thank you so much, Eric. On that note, never a dull moment in markets.
Thank you all for listening. And please do tune in again next time when I'm sure there will be lots more to dissect and discuss. Thank you.