(Bloomberg) -- The Mexican peso slumped the most in four years as increasing conflict in the Middle East sapped demand for the currency that has been one of the favorite targets for carry trades.

The peso tumbled more than 6% against the dollar as news began to filter through Friday of an Israel retaliatory strike on Iran, in what some in the market described as a “flash crash.” The currency had climbed to the strongest in almost nine years last month, driven by relatively high local interest rates and low currency volatility.

“While the Mexican peso has long been favored due to its high yields, it is now exposed to a reduction in EM local positions,” said Rajeev De Mello, a senior portfolio manager at GAMA Asset Management. “While I am usually less concerned about the effects of geopolitical events which tend to fade quickly, in this case, there is a potential for further escalation.”

The peso briefly tumbled to weaker 18.20 per dollar Friday before retracing some of those losses to trade at 17.3435, still down about 1.6% on the day.

A carry trade involving borrowing in dollars and buying the Mexican peso had returned 1.2% for this year through Thursday, among the top performers this year in emerging-market currencies, according to data compiled by Bloomberg.

The Middle East news set off considerable selling of the peso against the yen by retail investors in Japan, said Yoshio Iguchi, head of the market department at Traders Securities in Tokyo.

Read more: Massive Global Carry Trade Unwinding Hits the ‘Super Peso’

The outlook for carry trades is worsening as volatility increases. JPMorgan’s EM currency volatility index rose to as high as 7.7% this week, up from a four-year low of 6.09% in March. 

“The Mexican peso is one of the most crowded carry trades out there,” said Viraj Patel, global macro strategist at Vanda Research in London. “As they say, carry and short vol is like picking up nickels in front of a steamroller — that steamroller just started accelerating.”

--With assistance from Ruth Carson.

©2024 Bloomberg L.P.