The falling dollar and rising volatility have complicated the outlook for carry trades in the foreign exchange market

The falling dollar and the impact of interest rate hikesforeign exchange marketSigns of renewed volatility have prompted investors to reassess the popular carry trade and become more selective in choosing which currencies to invest in.

Carry trades - investment strategies that exploit differences in borrowing costs between countries - have paid off handsomely this year as most central banks have raised interest rates. Bank of America notes that the "most popular carry trade in the world" involves investors borrowing yen and converting it into Mexican pesos to buy Mexican bonds with much higher yields. Japanese one-year bonds yield about minus 0.1 per cent, while Mexican one-year bonds yield about 11 per cent, according to the data.

Kamakshya Trivedi, global head of FX, rates and emerging markets strategy at Goldman Sachs, said: "The carry trade has been very much watched in the first half of this year. About 70 per cent of movements in emerging market currencies can be explained by carry trades." Moreover, the Deutsche Bank emerging market carry strategy index recorded its best performance on record in the 12 months to May.

However, with the Federal Reserve, the European Central Bank and the Bank of Japan about to release their latest interest rate decisions and give clues on the outlook for monetary policy, this week's carry trade could take a hit.

1. Fear of overcrowding

Investors are starting to worry that carry trades could become overcrowded, which is not good news for investors. "You have to worry about some of the more crowded positions," said Stephen Gallo, European head of FX strategy at BMO Capital Markets, adding that increased volatility or falling interest rates in emerging markets could trigger a rush to exit.

James Athey, investment director at asset management giant Abrdn Plc, said: "Currencies like the Mexican peso have been heavily allocated for quite some time, and it feels like you're increasingly'picking up coins at the road roller '."

Volatility matters because gains from interest rate differentials can be wiped out by investors borrowing a stronger currency or investing in a weaker currency. The yen is already showing signs of a rebound, with the dollar falling from 145 to 137 against the yen in the first half of July. "I think that's enough to offset any carry trade gains," said Yujiro Goto, head of Japan currency strategy at Nomura.

Oliver Brennan, a currency volatility strategist at BNP Paribas, said volatility has been low this year because most central banks are raising interest rates in tandem and there are no major problems in the global economy.

For now, though, things look different. The Federal Reserve looks set to pause, the Bank of England still has room to raise rates, some emerging market central banks are considering rate cuts and traders are speculating on the BoJ's next move.

Volatility in the world's five biggest traded currencies fell to its lowest level in a year and a half in June but has since risen, according to the Chicago Mercantile Exchange's options-based volatility indicator. "From now on, the risk is less policy convergence and more uncertainty," Oliver Brennan said.

2. The depreciation of the dollar

Emerging markets are not the only focus, with investors also piling into US bonds that offer higher yields than many countries. However, the dollar has fallen 2 per cent against a basket of major currencies so far this month, and a sharp slowdown in US inflation in June has raised expectations that the Federal Reserve is about to end its rate rises.

Robin Winkler, FX strategist at Deutsche Bank, said such "mild disinflation" in the US could help carry trades in dollar-funded emerging markets continue to perform well. But he added: "A turn in the dollar is not necessarily good for carry trades in the G10 because the dollar has long been favoured." "The yen in particular, but also the Swiss franc, Swedish krona or Norwegian krona, have long been used as funding currencies to go long the dollar. So these currency pairs are under heavy pressure."

Mr. Kamakshya Trivedi says carry trades can still pay off, especially if emerging markets are buoyed. However, he advises against simply choosing the highest yielding currency. "In a world where economic growth is expected to be stronger, it makes sense to include currencies with considerable cyclical risk exposure, including the Brazilian real or the Korean won in Latin America," he says.

Geoff Yu, market strategist at Bank of New York Mellon, said that while the outlook was relatively modest, it was still uncertain. "Be selective now, you don't want to double or triple your risk exposure," he said.