On Carry and Other Tales...

I’m amazed with the number of academics, journalists and “pundits” in my field who keep on talking about “the carry trade” as if it’s some sort of cult… “The end of carry as we know it”… “Carry-trade silence”… “Carry makes a comeback!”…

Since last week, the carry trade has also found a mother, a father and some heavyweight patrons (like the Fed) who, apparently, keep on feeding it to monstrous and potentially self-destructive proportions.

I want to use this post to respond to some of the points raised in these op-eds, notably with regard to the role of policy in feeding carry trades and, in turn, asset bubbles. But before I get there, let me deal with the cult notion first...

The carry trade is NOT a cult… “Carry trade” is another way of describing “risk-taking” in financial markets. Anyone who invests their money in anything riskier than a safe, cash-like asset (e.g. US Treasury bills or money market funds) is effectively a carry trader: They are short cash and long a risky asset such as a stock, a corporate bond, a foreign currency, etc.

Indeed, the term “carry” is a literal description of that risk-taking process: When you buy shares in Microsoft, for example, you decide to forego the safety of a US T-bill and instead “carry” the risks embedded in Microsoft’s stock: Risks related to the company’s management, its capital structure, the growth and/or regulatory outlook of the IT industry and so on. Similarly, investors in a foreign currency have to “carry” risks related to the foreign country’s external imbalances, inflation prospects, politics, etc.

Now, to be fair, what many refer to as “carry trades” in the press are leveraged investments. In the above examples, investors use their own capital to make the risky investment. But when they are leveraged, they borrow multiples of their capital short-term and invest the funds in higher-yielding products (e.g. asset-backed securities or currencies like the Brazilian real) to make the spread.

The principle is exactly the same as before—risk taking—only that the use of leverage helps multiply profits in good times (and totally destroy them in bad times!).

OK... now to 2009. Since March this year, most risky assets have seen stellar returns, be it global stocks, corporate bonds, emerging market assets, higher-yielding currencies, etc. How big a role has the “carry trade” played in driving this price action?

Let’s see… One important driver has been the positive surprises in some parts of the real economy (remember those “green shoots”?) As a result, investors revised upwards their baseline forecasts on the economy. In statistical terms, their distribution of expected returns shifted to the right (i.e. a higher mean).

A second driver was the Herculean backstop measures by governments and central banks the world over, aimed at eliminating extreme downside risks. These basically cut off the left (negative) tail of investors’ expected-return distribution.

Neither of these can be said to have encouraged “carry trades” in the leveraged sense. But by shifting the distribution of expected payoffs from risky assets in a favorable way, both factors encouraged (some) investors get out of safe assets and take on risk.

Then you have the Fed’s (and other major central banks’) low-for-long interest rate policy. Is that contributing to “carry trades” and/or to asset price bubbles? There are at least three ways in which the low-for-long interest rates can impact asset prices:

First, the policy “condemns” investors to earning near-zero return on their cash assets for an extended period. This, together with a restored confidence, helps push investors out of zero-yielding cash towards riskier assets.

Asset flow data are supportive of such shifts, but it is important to understand that the low interest rate is only one of the drivers: Factors that changed the mean and the shape of the expected return distribution were arguably more important—recall that in the midst of the panic of 2008, investors were willing to sit on US Treasuries with negative (but certain) yield!

Second, the low interest rates are helping asset prices by boosting the profitability of banks. Think about it: Banks borrow short-term (e.g. depositors’ money or in money markets) and invest in long-term, higher-interest-rate assets like corporate or mortgage loans.

By fixing their borrowing rates at near zero, the Fed is helping banks make profits even in a difficult lending environment. In turn, this helps prevent the negative feedback loop we saw last year, when financial institutions fire-sold their risky investments to preserve their capital, driving down asset prices.

Third, the low-for-long rate can arguably encourage the fresh build up of leveraged carry trades: Investors could borrow short-term at low rates and invest in riskier assets like equities.

Maybe… but… Evidence of such leverage is lacking: Flow of funds data show that the liabilities of the US financial system on aggregate actually declined in Q2 2009--even as new capital was raised. True, we don’t have data yet for Q3, when asset prices kept shooting higher. But then, please, show me data that point to an ongoing “highly leveraged carry trade”! I’d love to see them, along with many in the markets who try to assess systemic risk on a real-time basis!

Even (even) if leverage were indeed occurring, the point that “traders are borrowing at negative 20% rates to invest on a highly leveraged basis on a mass of risky global assets” is grossly unfair: The “minus 20%” is the ex post cost of borrowing in dollars to invest in a basket of major foreign currencies, following the dollar’s depreciation since March.

But this ex-post analysis completely ignores the tremendous amount of uncertainty surrounding investors’ forecasts back then. No offence to my female cohorts in the industry, but it took gigantic balls to re-enter that market, especially when a LOT of asset managers were already deep underwater and capital preservation was the ultimate priority.

So to recap—low interest rates are just a small part of a broader set of policies and real-economy data that have helped boost asset prices since March. Importantly, based on available data, leverage has yet to manifest itself as the key driver of the price action.

Now, this doesn’t mean that systemic risk is not rising. In fact, IF that were so, the Fed should take notice. But is that so?

Some cite as evidence of systemic risk the high correlation between different risk assets recently (equities, commodities, EMs, etc). I’m not convinced: Since everything collapsed in tandem last year, the recovery in risk appetite should make everything recover in tandem. In other words, the high correlation is not necessarily a cause of alarm at this juncture.

Still.. high correlation means that, if there is a negative surprise, risk assets will all move down in tandem again. Which would be pretty bad! But here is the real crux of the debate: Have the prices of risky assets already moved “too much, too soon, too fast”? Are we already in bubble territory and, hence, at risk of a sharp correction as soon as “reality” strikes?

Well, it depends on your outlook of “reality” in the coming months/years, and on your framework for translating that outlook into a forecast for asset prices. It could indeed turn out that the world is in much worse shape than the average investor thinks (/hopes!)

But let’s get this straight: It is one thing to claim that current valuations reflect forecasts that are overly optimistic given the “true” state of the economy; and it’s another thing to say that the Fed’s low-for-long interest rates are feeding highly leveraged carry trades, which are in turn feeding asset bubbles.

I personally see the Fed’s promise of low interest rates for an extended period (or the ECB’s term lending at low fixed rates) as a plea to investors to take on risk. The idea is to help assets reflate; support consumption through positive wealth effects; and help lending to the real economy through positive valuation effects on collateral.

Investors are slowly heeding, taking on more risk, some even levering up—but still in an environment of heightened uncertainty about the future. We’ll find out “the truth” about the future when it happens. And some will get the chance to say “I told you so!”. But given the scale of today’s uncertainty, nobody can credibly claim that investors (or “carry traders”) are taking on risk for free!

PS My apologies to those who have recently received some of my old posts, looks like Blogger has gone about recylcing old ideas, please ignore them if they recur, I seem to have no control over this!