Carry trades can still be profitable, but the era of "effortless wins" may be over! Citi warns of narrowing spread risks.

Citigroup's U.S. FX trading team expects that although carry trade strategies may struggle to replicate the impressive returns of the previous period, they will continue to offer profit opportunities for investors. Fuad Muvdi, head of FX trading for the Americas at Citi, said these tradeswhich involve borrowing in low-yielding currencies and investing the funds in higher-return marketswill still benefit from higher interest rates in emerging markets. Meanwhile, after Fed officials decided last week not to raise rates, he expects the dollar to weaken slightly. Citi's bonds, currencies and commodities trading division reported its best third-quarter performance in at least a decade, with revenue reaching US$4.4 billion. Strong FX trading volumes offset the impact of relatively weak performance in the interest-rate trading business. Carry trades in most Latin American currencies have delivered returns Data show that year to date, the carry trade of going long the Colombian peso and short the dollar has returned about 26%. Similar strategies in the Argentine peso and Brazilian real have returned more than 14% and about 8.5%, respectively. However, the possibility of further rate hikes in some countries could narrow the spread between low-yielding and high-yielding currencies, thereby weakening carry trade returns. Citi remains bullish on the Colombian peso, Brazilian real and Argentine peso against the dollar. However, this strategy is unlikely to achieve returns as strong as those of recent years again. "I still believe in the carry trade strategy. But if you ask me whether I would put all my exposure into this strategy today? No, I don't think one should do that." Fuad Muvdi noted that persistent U.S. inflation could make market expectations for the U.S. interest rate outlook more hawkish, which is a risk worth watching. "Rate differentials may start to narrow, which would lead to a natural pullback in many of these currencies," he said. Although volatility surrounding Brazilian President Lula's re-election bid persists, Fuad Muvdi believes Brazil remains one of the markets with upside room. He said local interest rates in Brazil are around 15%, so even if the Brazilian real remains stable, investors can still earn quite substantial additional returns. Turning to other markets, he said market participants are becoming more cautious and more selective. Mexico is one of the markets where Citi has observed investors beginning to take some profits off the table. "There is so much noise in the current market that investors need to constantly watch factors specific to each local market, rather than treating this as a buy-and-forget trading strategy."