The Collapse of Carry Trades

In his usual brief style, jck at Alea displays the collapse of carry trades through the appreciation of the yen.

Put on your peril-sensitive sunglasses before viewing.  When I was at RealMoney, I wrote a lot about carry trades, and how the end would be ugly.  We are experiencing that now.

David Merkel
The Craving for Yield, Part 2
2/6/2007 2:55 PM EST

If you hang around bond investing long enough, you run into the phrase “carry trade.” It’s a simple concept where one borrows at a lower rate, and lends at a higher rate, just like any bank would do.

Free money, right? Yes and no. People make money in these trades often enough to make them popular, but there are often points where they blow up. The simplest example is when the Treasury yield curve is very steep, like it was in late 1993, or mid-2003 right after Alan Greenspan finished his last contest of “How much liquidity can I provide?” At that point, it seemingly paid to borrow short and buy longer dated Treasuries, clipping the interest spread. That works well when interest rates are falling, or when the FOMC is on hold at the bottom of the cycle, but once the hint that the first tightening might occur, it doesn’t work well until the first loosening is hinted.

Carry trades can involve other factors as well. Some creditworthy entity can borrow cheaply, and invest in less creditworthy or more illiquid paper, capturing a spread. That trade also goes in cycles; good to do it when everyone is scared to death, as in late 2002. Bad to do it in late 1999-2000, as the negative side of the credit cycle kicks in.

Carry trades can involve different currencies. Borrow in the low interest rate currency (Yen, Swiss Francs, Offshore Yuan), and invest in the high interest rate currency (US dollars, NZ dollars, Australian dollars, Korean Won, Indian Rupee, etc.) Again, it all depends where you are in the cycle, as to whether this is a good trade or not. The weak tendency will be for low interest rate currencies to appreciate versus high interest rate currencies, but in the short run, currency movements are somewhat random.

What fascinates me in the current environment is the size and variety of all the carry trades being put on at present. CDOs of all sorts. Borrowing in developed markets and investing in emerging markets currencies. Levering up nonprime commercial paper. Borrowing offshore in Yuan. Borrowing short to finance paper with short embedded call options. Corporate, RMBS, CMBS and ABS spreads are tight.

When I think of all of the different risks that can be taken in bonds (duration, convexity, credit/equity, illiquidity, currency, etc.) they are all being taken now, and at relatively high levels. There is an exception. Duration risk is not being taken because of invested yield curves. (But who is borrowing long to lend short? Not many I hope.)

The danger here is not immediate. As with most topping processes, it is just that, a process. Bubbles pop when cash flow proves insufficient to finance them. Cash flow is still sufficient now. Banks are still growing their balance sheets faster than their central banks. Petrodollars and Asian surpluses are still being recycled. Wealthy investors are still for the most part bullish. We’re not to the point of no return yet; the sun is shining amid large cumulus clouds. But as those clouds cumulate, we should prepare for rain. Okay, snow.

Position: none

Alas, but the boom has given way to a bust, andAll the king’s horses and all the king’s men, Couldn’t put Humpty together again.” Sad times these, but they had to come. There was too much leverage in the the system, and now leverage is collapsing, and the value of assets whose prices were artificially high due to the temporary additional purchasing power that leverage afforded.

Have a wonderful day amid the chaos, and be grateful if you have food, shelter, clothing, family, friends, and peace with God.