Amidst the turmoil of Middle Eastern wars shaking global assets unexpectedly "feed" foreign exchange arbitrage trading! Oil prices "east wind" boost the best returns in three years.

In the $9.5 trillion foreign exchange market in Japan, arbitrage trading - borrowing low-interest rate currencies to invest in high-interest rate currencies - one of the most widely used strategies, is being boosted by surging oil prices and in some cases is achieving its best returns in three years. While escalating oil prices are disrupting other assets, the stock market and bond market are experiencing severe volatility due to the Middle East conflict. Leah Traub, portfolio manager and head of the currency team at Lord Abbett & Co., which manages around $248 billion in assets, said, "The strong performance of foreign exchange arbitrage trading is mainly due to commodities." He added that some high-yielding currencies "benefit from the rise in oil and natural gas prices." Traders are borrowing currencies from countries (such as Japan) that are more vulnerable to the impact of rising energy costs, and investing in economies that benefit from the increase in energy prices. They typically pair commodity-exporting countries with other high-yield currencies to reduce the risk of relying on a single position. A popular strategy is to borrow Japanese yen and buy a basket of currencies including the Brazilian real, Colombian peso, and Turkish lira. Data shows that since the US launched attacks on Iran, this strategy has returned over 2%, and the return so far this year has exceeded 6% - the strongest start since 2023. In the global market, as conflicts push crude oil prices to multi-year highs, commodities are playing an increasingly important role. Higher prices and relatively higher interest rates in some economies help offset the volatility that typically erodes arbitrage trading returns. In Brazil, the one-month "return-to-volatility ratio" (a key indicator of the attractiveness of this strategy) remains high compared to other markets. This has prompted Legacy Capital Gestora de Recursos Ltda., a hedge fund based in So Paulo with around $3 billion in assets under management, to invest in the real and other currencies in Brazil where the benchmark interest rate is 15%. The company is funding these trades by shorting developed market currencies with counter-cyclical characteristics. Felipe Guerra, co-founder and chief investment officer of the company, said, "We will maintain current positions." As a preferred target for arbitrage traders, Brazil continues to benefit from the country's growing oil production and export revenue. Thierry Wizman, global foreign exchange and rates strategist at Macquarie Group, said, "I won't shy away from well-structured arbitrage trades, such as going long on currencies of oil-producing countries far from conflict zones. Brazil, which has increased oil production in recent years, particularly benefits from this." Latin American currencies outperform major peers Some investors believe that broader factors are also supporting emerging market currencies, including relatively strong economic growth and higher interest rates compared to developed markets. Anna Wu, cross-asset investment strategist at Van Eck Associates, said, "Looking more broadly, over the past year or so, emerging markets have performed well due to structural supports such as high growth, monetary policy, and overall weakness of the US dollar." The performance of the yen - the most widely used funding currency globally - also plays a role. As a traditional safe-haven currency during times of geopolitical unrest, the yen has not shown sustained appreciation. With the Bank of Japan maintaining a relatively loose policy, Japan's low-interest-rate environment continues to solidify its position as the preferred funding currency, even amid increased volatility. Of course, a sharp appreciation of the yen - triggered by inflows of safe-haven funds or policy interventions by Japanese authorities - could quickly erode these returns. Noureldeen Al Hammoury, Chief Market Strategist at Equiti Group, said, "If the conflict escalates and triggers global risk aversion, investors are likely to rush to cover their arbitrage trades by buying yen. This could lead to a sharp appreciation of the yen and significant market volatility." Moreover, with constant changes in news related to the war, emerging markets remain risky. This month, investors engaging in arbitrage trades using the US dollar have suffered losses as the dollar strengthened against most emerging market currencies. Investors and strategists emphasize that the duration of the war will be a key factor in determining whether arbitrage-driven positions can be sustained. Citigroup strategists, including Dirk Willer and Adam Pickett, closed their last batch of recommended emerging market arbitrage positions last week due to the high uncertainty and volatility caused by the conflict. However, for now, these unusual multiple forces generated by the war continue to help sustain this trade, especially as Japanese investors have not signaled a significant shift in funds back to the domestic market. Matthias Scheiber, Senior Portfolio Manager at Allspring Global Investments, said, "Historically, in situations where risk aversion leads to capital inflows, you would expect the yen to strengthen. But in the case of Japan, the export openness and cautious policy stance of the Bank of Japan help maintain the weakness of the yen."