Mexican peso jumps as lower US yields revive the carry trade

The Mexican peso was the biggest mover in the latest European Central Bank (ECB) reference rates. The USD/MXN fixing for 6 October fell 1.13% to 17.945, from 18.15 on 5 October, and FXStreet reports that lower US Treasury yields revived the carry trade into the peso.

A falling USD/MXN means each dollar buys fewer pesos, so the peso got stronger. FXStreet says the dollar weakened on profit-taking and lower yields while traders waited for the minutes of the Federal Reserve's last meeting, with USD/MXN trading at 17.97 later in the day. According to FXStreet, long-dated Treasury yields eased from Monday's multi-decade highs as oil prices fell. Our sister site has a broader look at the soft dollar and the peso's lead in the fixings. You can follow the pair on a USD/MXN chart.

What is a carry trade?

A carry trade means borrowing, or selling, a currency with a low interest rate and using the money to hold a currency with a higher interest rate. The trader aims to earn the difference between the two rates. That difference is called the carry.

The currency you borrow is the funding currency. The currency you hold is the target currency. Emerging-market currencies such as the peso are often target currencies because their interest rates tend to be higher.

The catch is the exchange rate. Interest builds up slowly, day by day. A currency move can arrive in one session. If the target currency weakens, the loss on the exchange rate can wipe out the interest earned. That is why carry trades are sensitive to news that changes the rate gap, such as moves in US yields. A yield is the return a bond pays, expressed as a yearly percentage. For reference, investingLive reports that the US Treasury sold 3-year notes at a high yield of 4.932% on 6 October. When US yields fall, holding dollars pays relatively less, and higher-yielding currencies can look more attractive.

A worked example

We use the ECB fixings only. The pack does not include Mexico's interest rate, so this example shows the currency side of a carry trade, which is where most of the risk sits.

Good day for the trade (5 to 6 October):

1. Convert $10,000 into pesos at the 18.15 fixing: 10,000 × 18.15 = 181,500 pesos.
2. Convert back at the 17.945 fixing: 181,500 ÷ 17.945 = about $10,114.24.
3. Currency gain: $10,114.24 − $10,000 = about $114.24, or roughly 1.14%.

Bad stretch for the trade (30 September to 2 October):

1. Convert $10,000 at the 18.126 fixing: 10,000 × 18.126 = 181,260 pesos.
2. Convert back at the 18.335 fixing: 181,260 ÷ 18.335 = about $9,886.
3. Currency loss: about $114, or roughly 1.1%.

Over five fixings the pair swung both ways by similar amounts. Any interest earned would be added on top of these currency results, but it would accrue slowly.

Why it matters for new traders

Carry trades can look like steady income. The fixings above show the real driver of short-term results is often the exchange rate, not the interest. A move of just over 1% in a day can equal or exceed the carry earned over a long period.

Carry trades also depend on mood. investingLive noted that risk sentiment improved on 6 October as oil fell and bonds rose. Calm markets tend to suit carry trades. When fear rises, traders often unwind them quickly, and the target currency can drop sharply. Remember too that ECB fixings are one reference rate per business day, not live prices.

Key terms

• Carry trade: holding a high-interest currency funded by a low-interest one to earn the rate gap.
• Carry: the interest-rate difference the trader earns.
• Funding currency: the low-yielding currency that is borrowed or sold.
• Target currency: the higher-yielding currency that is held.
• Yield: the yearly return on a bond, as a percentage.
• Unwind: closing carry trades, often all at once when markets turn fearful.