Emerging Market Arbitrage Trades Outperform Everything for Seven Consecutive Quarters

On August 23, Bloomberg reported that emerging market arbitrage trades financed in U.S. dollars have recorded positive returns for the seventh consecutive quarter, marking the longest winning streak since 2008.

According to Bloomberg's eight major emerging market currency arbitrage indices, this trade has accumulated a return of approximately 22% since the end of 2024. In the same period, U.S. Treasury bonds returned 5.9%, emerging market sovereign dollar bonds 14%, and emerging market corporate bonds 10%—the arbitrage trades outperformed U.S. Treasuries by nearly four times.

Cathy Hepworth, head of PGIM's $1.5 trillion emerging market debt team, when asked about the most reliable theme, responded with "arbitrage, arbitrage, arbitrage." Her exact words were, "It's an arbitrage world," with a straightforward reason: "There is a massive amount of money looking for yield."

The practice of arbitrage trading itself is not complicated: borrow money in low-interest currencies like U.S. dollars, Japanese yen, or euros, convert it into high-interest currencies like the Turkish lira to buy bonds or money market funds, and earn the interest spread. The interest returns in Turkey can exceed 40%.

How have these seven quarters unfolded?

The interest spread is the foundation, but what truly doubled the returns is the exchange rate. The U.S. dollar has weakened against emerging market currencies outside Asia, while it has also become cheaper against low-interest counterparts like the euro and Swiss franc—both sides are helping. The most extreme case is Colombia: a 12% bond return combined with a 45% appreciation in the spot rate. Even in Turkey, where the lira has depreciated by 26% against the dollar, the yield of over 32% on 10-year local currency bonds keeps investors in the profit zone.

In the past 12 months, dollar-financed arbitrage trades have earned 48% on the Colombian peso, 23% on the Turkish lira, 21% on the Brazilian real, 19% on the Mexican peso, and 18% on the South African rand.

There was a real test in between. The recorded chain of events is as follows: in early July, arbitrage funds had clearly shifted from developed markets to emerging markets, betting against the dollar; on July 23, the yen fell to a 40-year low; in early August, the U.S. and Japan implemented historic joint market interventions.

The sudden rise of the yen in August 2024 had previously shaken global markets—Bloomberg's emerging market forex arbitrage risk premium index fell by 4% at that time. However, this time, the same index only dropped by about 1% after the intervention. The reason is that the funding has already switched to other financing currencies: the yen's position has been taken over by the euro, Swiss franc, and U.S. dollar. Thierry Larose, a portfolio manager at Swiss asset management firm Vontobel, stated, "The threshold for disorderly liquidations is higher than we thought a few weeks ago," and he continues to engage in arbitrage but avoids the yen.

The intervention also did not change the yen's situation. By mid-August, the yen had returned to the 159-160 range; although the short positions on the yen held by hedge funds were halved to 59,526 contracts since the intervention, some arbitrageurs took advantage of the rebound to rebuild their shorts at better prices. On August 17, the emerging market currency index hit a historical high of 1906.98.

In the past week, there has been further accumulation. The U.S. Treasury announced on Wednesday that it would increase long-term bond repurchases. Daniel Von Ahlen, head of macro strategy at TS Lombard, wrote in a report to clients, "The U.S. government's tolerance for rising bond yields seems very low, which is catalyzing trades to go long on emerging market arbitrage," and the company's emerging market forex arbitrage mechanism indicators "have improved again, reinforcing our confidence."

What is the market watching next?

First is when the Federal Reserve will act. This is the single largest risk point for the entire trade. Goldman Sachs' chief forex and emerging market strategist Kamakshya Trivedi assesses that "the improvement in inflation is sufficient for the Fed to remain on hold," but also warns that rising long-term rates pose a recent threat—provided the increase is not too rapid, emerging market currencies with high real interest rates can still provide positive returns. Ning Sun, a senior emerging market strategist at State Street, expressed more directly: U.S. data has not weakened enough to reverse the risk appetite supporting arbitrage trades.

The second is the level of congestion. The report explicitly mentions that this trade could become a victim of its own success—there is too much money. This is the classic death of arbitrage trading: everyone crowds on the same side, and when the reverse volatility comes, it leads to a stampede.

Of course, high interest rates are also a key focus, and the market wants to see how long they can be maintained. One supporting factor is that central banks in Latin America and Eastern Europe have maintained high policy rates to curb post-pandemic inflation, while the situation in the Middle East and high energy prices are also preventing them from shifting to easing. Both of these conditions are exogenous.

Alejo Czerwonko, chief investment officer for emerging markets at UBS Americas, prefers to finance with euros and Canadian dollars, going long on the South African rand and Mexican peso; PGIM's Hepworth is looking at frontier markets in sub-Saharan Africa, as well as Turkey, Colombia, and Brazil.

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