As Japan's interest rates rise, the classic 'yen carry trade' is unwinding. Investors are now turning to the low-interest-rate Chinese renminbi (CNY) to borrow cheaply and invest in higher-yielding global assets, making the CNY a new cornerstone of this popular financial strategy.

The success of the current EM FX carry trade isn't driven by wide interest rate differentials, which are not historically high. Instead, the strategy is performing well because a resilient global growth environment is suppressing currency volatility, making it profitable to hold high-yielding currencies against low-yielders.

A world of persistent inflation and hawkish central banks creates a prime environment for carry trades, even with moderating growth. Within the G10, currencies of energy exporters with high yields, like the Australian Dollar and Norwegian Krone, are particularly attractive. Their carry advantage over the US dollar is at its highest level in nearly a decade.

A decoupling is occurring where EM high-yield currencies are outperforming DM high-beta currencies. Investors are increasingly using DM currencies as funders to capture attractive carry in select EMs like South Africa (precious metals), Mexico (stable carry), and Hungary (improving fundamentals).

Despite an expectedly hawkish European Central Bank (ECB) meeting, any resulting Euro strength should be sold into. The rate hikes are driven by persistent inflation, not robust growth, which limits the currency's upside. This positions the Euro as an underperforming 'funder' currency against higher-yielding alternatives.

For FX carry strategies, inflation is a more critical driver than growth. This is because inflation forces divergent central bank responses, creating the yield dispersion that carry trades exploit. Growth only becomes the dominant factor during a recessionary shock, when carry strategies typically collapse.

While broad emerging market currency indices appear to have stalled, this view is misleading. A deeper look reveals that the "carry theme"—investing in high-yielding currencies funded by low-yielding ones—has fully recovered and continues to perform very strongly, highlighting significant underlying dispersion and opportunity.

A notable divergence has appeared in carry strategies. While popular Emerging Market (EM) carry baskets have suffered moderate losses, G10 carry factors have been remarkably strong, gaining 4% since early April. This G10 performance is highly concentrated in a few positions (long AUD/NOK, short JPY/SEK) that are benefiting from multiple tailwinds simultaneously.

Instead of directly shorting the US dollar, which can be costly, traders can use the Canadian dollar (CAD) as a more profitable proxy. This approach offers a better "carry" advantage due to interest rate differentials, while still capturing the downside of a weakening USD, especially as the Bank of Canada's policy mirrors the Fed's dovishness.