BofA: What Happens To Carry After Central Banks Cut Rates?

Bank of America note that “long BRL, MXN, and HUF vs EUR have been some of the popular FX carry trades since 2021. With the market now expecting several EM central banks to cut rates in 2023, we examine historical FX price actions for BRL, MXN, and HUF vs EUR when each EM central bank first cuts rates after a rate hike cycle. Historical analogs see BRL more at risk than MXN and HUF. The historical average 6-month loss after the first rate cut for MXN and HUF would still be well-contained by the current level of carry, but not for BRL. For this year, we are more optimistic on BRL than in the past, partly due to supportive real rate and fiscal upside. To the contrary, MXN carry unwind in this cycle could turn out to be worse than in the past, due to overcrowded position and MXN's sensitivity to U.S.-originated risk-off shocks. Investors may consider owning relatively cheap 1-Year EUR/BRL skew as a hedge, in our view.”