2020 “Globie”: The Carry Trade

Yves here. So many books, so little time! I might quibble at the margin (as in I might take the view that their definition of “carry trade” is a bit overbroad) but there’s no question that carry trades have been major drivers of financial crises and instability. In the 2007-2008 financial crisis, the unwind of the yen carry trade would lead investors to dump positions, often of their currently best performing assets, which would lead to sudden swoons in markets like gold that seemed to have nothing to do with that day’s move in yen prices.

One incentive for this behavior is the so-called resume put. As the Financial Times’ John Dizard put it:

In Wall Street’s distant past, before the fall of 2008, financial markets people had what was called a “résumé put”. If the securities or portfolio strategy you were selling blew up on the client, you moved your previously pocketed bonuses to another custodian, put (sold) the securities to the market, and put out your résumé to other firms, or, especially, brokers with whom you had done business. Your problem was solved.

Dizard argued in 2014 that this approach didn’t work so well in a downsized securities and brokerage business, but with perma-ZIRP-induced inflated assets, the fund management business seems healthy, leaving plenty of places to land, at least in the case of garden-variety train wrecks.

By Joseph P. Joyce, Professor of Economics at Wellesley College. Originally published at Capital Ebbs and Flows

It is time to announce the recipient of this year’s “Globie”, i.e., the Globalization Book of the Year. The award gives me a chance to draw attention to a book that is particularly insightful about some aspect of globalization. This year’s winner is The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee and Kevin Coldiron. The prize lacks any monetary reward, but no doubt the distinction of having won has value in itself. Previous winners are listed at the bottom.

The classic carry trade involves borrowing and investing in different currencies. For many years the Japanese yen served as the source of cheap loans that could then be exchanged for Australian dollars that yielded a higher return. At the end of the period the dollars would be exchanged for yen, and the loan repaid. As long as the funding currency had not appreciated in value, the trader would profit from the difference in returns. A profitable carry trade, however, violates uncovered interest rate parity, which stipulates that any difference in returns should be offset by an expected appreciation of the funding currency. At times the currencies would realign, and purchasing the originating currency to repay the loan could eliminate any previous gains.

The authors extend the concept of carry trades to include all those transactions that provide a stream of income but are subject to the risk of “…a sudden loss when a particular event occurs or when underlying asset values change substantially.”  Since carry transactions are based on borrowing, leverage is a key component. Buying stock on margin, for example, is another form of carry trade, as is a private equity leveraged buyout.

The trader benefits only as long as asset prices remain close to their current levels. Volatility can wipe out a position, and the financial losses can spill over to the economy. Those negative consequences bring central banks into the financial markets. Their intervention may reestablish stability, but it allows those who would have suffered a loss to transfer that loss to the public sector. Central bankers acting as lenders of last resort, the authors write, “…underwrite some of the losses associated with carry. This encourages further growth of carry, and a self-reinforcing cycle develops.”

The authors investigate the spread of carry trade and its broad scope, including the transformation of global financial markets. Firms in emerging markets use capital markets to obtain finance from cheaper foreign sources. Changes in the VIX measure of volatility have international reverberations and engender global financial cycles.The Federal Reserve’s use of swap facilities to help their counterparts in other countries assist domestic institutions that face a dollar liquidity squeeze demonstrates that carry crashes require global responses.

The authors also claim that the carry trade increases income and wealth inequality, as only those with sufficient assets engage in carry and profit from central bank intervention.  The continuing returns from these transactions flow to those who know how the system works and how to exploit it. These rewards act as an incentive to draw more people to finance, contributing to the growth of the financial sector.

The book was written before the events of this year, but the analysis is very relevant. In March, financial markets crashed as the global extent of the pandemic became evident. Stock prices plunged and foreign capital fled emerging markets. This outbreak of volatility engendered a massive response by the Federal Reserve that dwarfed their actions in the 2008-09 crisis (seehere and here for overviews of central bank policies). The markets responded by regaining lost ground, and the Standard & Poor’s 500 has set new highs.

After the latest meeting of the Federal Open Market Committee, the Federal Reserve reiterated its pledge to keep  the target range for the Federal Funds Rate at 0 to ¼% “…until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” The Fed’s commitment to low interest rates provides an incentive for more carry trade activities, and these are appearing. Special Purpose Acquisition Company (SPACS), for example, are pools of money that are established to purchase privately-held firms and take them public, profiting from the IPO price. The SPACS investors do not know which company will be acquired or when, and they may not realize a return for years. But they are providing liquidity, and at minimal cost due to the Federal Reserve’s interest rate policy.

Lee, Lee and Coldiron convincingly demonstrate that the carry trade has contributed to the financialization of the economy, which has grave and disturbing implications. As the subtitle of the book indicates, the suppression of volatility leads to lower growth and recurring crises. When a vaccine for the coronavirus is available, there will undoubtedly be a burst of financial activity that will prepare the way for the next crisis. We will not be able to say that we were never warned.

An interview with the authors is available on the podcast Hidden Forces.

2019    Branko Milanovic, Capitalism Alone: the Future of the System That Rules the World

2018    Adam Tooze,  Crashed: How a Decade of Financial Crises Changed the World

2017    Stephen D. King, Grave New World: The End of Globalization, the Return of History

2016    Branko Milanovic, Global Inequality

2015    Benjamin J. Cohen. Currency Power: Understanding Monetary Rivalry

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17 comments

  1. Upwithfiat

    Since carry transactions are based on borrowing,

    Aren’t banks the source of the lowest interest loans?

    And aren’t bank “loans” not really loans but the creation of new liabilities for fiat?

    And aren’t bank liabilities for fiat largely a sham since, for example, the non-bank private sector may not even use fiat except for grubby coins and small denomination Central Bank Notes? Not to mention the fiat lender/asset buyer of last resort, the Central Bank?

    Then aren’t carry trades subsidized by government in our so-called “free market economy”?

    Reply
    1. PeasantParty

      I haven’t read the specific books listed above, that Yves references but there is one man that I am very fond of. He is an Economic specialist, and has a pod cast where he explains all this financial hocus pocus in terms that even I can understand. It will make you angry when you find out even more of the dirty dealings, but at least you will know. Maybe you can do a little binge watching, and note taking over the weekend. I highly suggest you listen to the work from, John Titus at the link included here.

      Reply
  2. Harry

    “but with perma-ZIRP-induced inflated assets, the fund management business seems healthy, leaving plenty of places to land, at least in the case of garden-variety train wrecks.”

    Fund management is also downsizing. When I lunch with old friends on that side of the business many live in fear of not being able to rent out their excessively large NYC town homes.

    Doesnt help that hedge funds are in such dire straights. They keep removing chairs from the game. Im not surprised El Erian took that wonderful gig at Queen’s College.

    Who is gonna pay him 100mn a year now?

    Reply
  3. ChrisAtRU

    Thanks for this! I’ve always been fascinated by the carry trade. Also interested to know what your quibble is per the definition! ;-)

    Reply
    1. Hickory nut

      Me too. Seems like the authors’ definition just means ‘any leveraged investment’ – where you owe interest+principle back on the funds you invest, and you’re hoping the returns exceed that. “Carry trade” was specific to currencies I thought. Curious about Yves’ understanding.

      Reply
        1. ChrisAtRU

          Found this from NC thirteen years ago: “The Carry Trade Returns”.

          From our dear and esteemed NC founder’s introduction:

          For those new to the term, the “carry trade” in simple terms is when investors borrow in a currency with low interest rates (in this case, the yen) and use the proceeds to make investments in countries where the prevailing interest rates are high (Australia, New Zealand, or for the more conservative, the US).

          The risk is that the currency in which you’ve borrowed appreciates, wiping out the difference between your low borrowing rate and your higher investment return.

          I suspect Yves’ quibble is with the extension of the definition by the authors of this article here:

          The authors extend the concept of carry trades to include all those transactions that provide a stream of income but are subject to the risk of “…a sudden loss when a particular event occurs or when underlying asset values change substantially.” Since carry transactions are based on borrowing, leverage is a key component. Buying stock on margin, for example, is another form of carry trade, as is a private equity leveraged buyout.

          Reply
  4. Susan the other

    Isn’t it sort of assuming a broken can opener for analysts to say that the carry trade goes against good practice because it takes advantage of currency volatility? So that nothing balances out the profiteering because the regulations never catch up with it. Technically this should all be balanced out by some “adjustment” to currency fluctuations in a real-time manner? (What is the effective difference between that and derivatives contracts?) Since when? Trading (in anything) is the oldest profession and it didn’t survive this long by quitting quick profits. So am I reading this premise correctly – that because traders are speculating on currencies and other stuff and then hedging their bets with derivatives, thereby reducing possible losses – that this creates a “suppression of volatility” and sets in motion “decaying growth and recurring crisis” that will end in aimless economic drift of some kind? It would be more reassuring to hear someone just say it’s over. Nothing lasts forever. So let’s get on with civilization while there is still time. We need cooperation far more than we need insurance policies.

    Reply
  5. Chauncey Gardiner

    Trying to fully understand what is going on here, but IMO funds borrowed under carry trade arrangements are being used almost exclusively for speculations in the financial and real estate markets in a massive ZIRP-enabled feedback loop where rising debt is being justified by rising prices that are themselves supported by rising debt.

    As in the Great Depression of the 1930s, low US Treasury bond yields are signaling recognition of speculative risk and a desire for safety and liquidity, low real economic growth, low inflation expectations, and in a seeming paradox after trillions of dollars in Fed QE: tight money.

    Offshore US dollar liquidity through the organic eurodollar market is key to the global financial system. There is a shortage of Repo collateral in part due to Fed QE absorbing a significant portion of net new issuance of Treasury debt which is in turn reducing global liquidity.

    Reply
    1. hickory nut

      How can us treasury bond yields signify ‘recognition’ or ‘desire’ if substantial amounts are being bought up by the Fed to maintain interest rates? Low interest rates are a policy choice, not reflection of investor sentiment.

      Or am I missing something?

      Reply
      1. Chauncey Gardiner

        Perhaps Treasury rates are both a policy choice and a reflection of investors’ needs and preferences that transcends sentiment as the Fed is not buying the entire amount of Treasury debt issuance.

        Reply
      1. apleb

        The points are garbage. There is no reason given why the Fed would hoard coins instead of giving them out to banks. Especially since coins make only a miniscule amount of payments in any country, since the denominations are so small compared to all the other ways.
        Even if the Fed brings all payments, seignorage, and whatever else under their grubby paws: what’s the point? They don’t really make more money, personally or institutionally. They don’t get more power. There is nothing in it for them.

        Going from cash and coins to purely electronic transactions, that is something they want, since it gives them power, or rather their masters whoever that may be. That actually helps them: an economy is easier to direct or manipulate this way, which is their intended purpose for good or ill.

        Making coins scarce but not cash is not the way to do this however. This is a typical video, typical media, MSM or alternative, product: it takes ages to get to the point, and when you think about it, the point is bogus since it doesn’t tell you what it claims to do, there is no plausible reason given. At all.

        So if you find a good point or more, I’d ask you to please point them out to me, maybe I’m just too dense to understand something one could handle in a single paragraph of text when obviously a “short” ten minute video is needed.

        PS: I want those wasted ten minutes back!

        Reply
        1. Upwithfiat

          The point that we have TWO monetary sovereigns is good.

          The point about coins being an asset and FRNs a liability is good. (In case we should go with $trillion coins.)

          And hoarding coins as an asset is plausible so as to keep them for future use as sterilizers. (Since banks don’t use coins to settle inter-bank balances.)

          I’ve only seen the one podcast though but so far it’s been worth my time.

          Reply

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