For how long can the carry trade go on?

by on June 24, 2013 at 3:34 pm in Economics | Permalink

Here is a rather scary article by @exantefactor, consider it speculative and please use with care, nonetheless I thought it was worth a ponder.  Here is one bit:

This QE carry trade nightmare became reality last week, and the Eurodollar pit was ground zero. As carry trade asset prices come under pressure due to rising US real interest rates, investors are forced to sell Eurodollars to hedge higher financing costs and negative gamma exposure. The magnitude of the selling implies that there is a lot of money exposed, but it’s not clear what still needs to unwind.

Last week, there were rumors of bond dealers who were both liquidating MBS inventory and ceasing to bid on these securities until quarter end. There were also accounts of liquidity drying up in the Treasury market.  When dealers cease to bid on the assets that collateralize the loans for carry trades, the system is frozen. This is serious.

If you believe the accounts in the media, you would think the Fed believes the move in the front end of the yield curve, including the Eurodollar strip, is a misinterpretation of Fed tightening. The Eurodollar market not only has an interest rate component but also a credit component, and one interpretation of the blow out in the strip is a spike in banking system credit risk.

…Make no mistake about it: Bernanke is blowing up the QE trade he engineered. The question for markets at this juncture is not what assets are exposed to this trade but rather how much capital is exposed and who will take the other side of the unwind. The move in the most liquid part of the rates curve suggests that the position is very deep; the reluctance of dealers to bid on financing collateral suggests the bid is very shallow. Finding a level where that bid/ask comes together is likely to be a very disruptive process, and if history is any guide, the “collateral” damage will be felt around the world.

The full article is here, hat tip goes to Izabella Kaminska.  Is “we haven’t been understanding the carry trade” the key to unpacking some otherwise puzzling recent asset price movements?

Andreas Moser June 24, 2013 at 3:41 pm

As long as the curry trade will go on, I am fine.

malcom digest June 24, 2013 at 4:20 pm

Am I understanding this incorrectly or doesn’t the market reaction to this news really expose the fact that the current round of QE is really just a mechanism to transfer money to the ibanks and traders.

Wouldn’t it provide better overall quality of life improvements if the federal reserve did business directly with local or regional banks or even better just bypassed the banks entirely and did business directly with the borrowers.

Abe Froman June 24, 2013 at 4:29 pm

I don’t mean to be flippant, but I think its now crystal clear that QE lowered rates in the market for everyone. Just look at what the threat of the taper has done to normal mortgage rates. Why on earth would buying from local banks result in even lower rates?

It doesn’t matter who the Fed buys its bonds from. Suppose the Fed buys its $85 billion in bonds from First State Bank of Main Street – a fictional, local bank. It’s still going to have to pay market rate… You don’t want the Fed paying $100 Billion for $85 billion in paper that is only held by small banks. In the end, it doesn’t matter. Market price is market price.

malcom digest June 24, 2013 at 6:02 pm

I think it matters because there will be a small profit on each purchase that goes to the seller with each intermediary taking a small slice. Which means that a small slice of all the new money being created is being directly transferred to whoever the fed is doing business with.

Willitts June 24, 2013 at 10:43 pm

Who’s going to make markets? First Community Savings Bank of West Bumscrew?

These “slices” are costly and only the banks with the biggest slicers can cut them.

Nobody I know ever made a loan based on a Series EE savings bond.

malcom digest June 25, 2013 at 2:20 pm

Based on the reactions of the banks/traders to the feds announcement, it’s clear that the only reason they are doing business in these areas is because the fed is willing to take them off their hands. In which case it’s irrelevant whether the institution is capable of doing the transaction on their own or not. The market is made by the fed buying the bonds, not by the banks doing the lending.

It’s similar to the period when the fed was loaning money at 0% and the big banks were buying treasury bonds with the borrowed money. A straight transfer of tax dollars to the big banks.

Boris June 24, 2013 at 4:20 pm

You know what’s nice? I still most of the canned goods I bought last time you started blogging about things like this…

dearieme June 24, 2013 at 5:40 pm

Yeah, we still have an awful lot of tins of beans. It’s the supply chain disruption that I worry about – high inflation is some way off, I’d guess. First we have to get through the severe deflation, don’t you think|?

Bill June 24, 2013 at 4:53 pm

I am waiting for someone to chime in on imminent inflation and the need to buy gold.

Or, maybe the wonderful effects of austerity on European recovery.

duh June 24, 2013 at 7:43 pm

You forgot “How awesome Bitcoin will be when teh sheepz are eating dog food as a delicacy.”

KenF June 24, 2013 at 5:58 pm

The mistake is to try to read something into short-term asset price movements. The mistake is to try to solve the “puzzle” rather than to just accept that traders can move markets in times of uncertainty and change.

KenF June 24, 2013 at 6:11 pm

The myth is that there is some underlying wisdom to how markets react in the short-term. So you can see an event and look how markets react immediately to judge that event. Traders know this myth, and know that other people believe this myth, and so capitalize on it by generating outsized reactions. Then they flood the media with logical “reasons” for these market movements. The media is always looking for “explanations” for market movements, so they eat these up.

mpowell June 24, 2013 at 6:25 pm

The other point is, who cares if some traders lose a ton of money on their carry trades? The fed’s job is fairly straightfoward. They need to manage inflation and unemployment. If the correct action is to extend QE, they should do so. If the correct action is to wind down QE and raise rates a little early, that is the correct response. If some traders made bets on LIBOR spreads in 2016/7 that turn out to be wrong, so what? That’s not the fed’s job to worry about. The fed should try to adjust policy as slowly as possible to avoid markets spikes clouding data on real rates moving forward but while unwinding QE will create winners and losers among traders, it shouldn’t have to negatively effect the availability of credit in the economy.

zbicyclist June 24, 2013 at 7:59 pm

+1, so long as it’s the traders who pay, not governments who bail them out.

derek June 24, 2013 at 10:03 pm

It has been pretty clear since 2008 that the way to make money in the financial market is to go along with the Fed. If you figured that you could cross them in some way, you lost. I would suggest that this has been the basis of their ability to do anything at all. If they do as you suggest, and it becomes dangerous to follow their lead then they will lose control of the situation. Price fixing schemes work as long as everyone buys and sells at the price that you set.

mpowell June 25, 2013 at 2:20 pm

There is some truth to what you say, but it is simply not the case that the fed would ever be powerless. Credibility allows them to move the market by stating a price target and then not doing very much. A lack of credibility means they have to do a lot more. But the fed has pretty much unlimited ammo! So I don’t see this as that much of an issue. But also pay attention to what is happening here. Traders are betting on short term LIBOR rates 2-3 years down the road and they are relying on close fed guidance for their bets. That’s not the same thing as current interest rates and it is an inherently risky proposition.

TallDave June 24, 2013 at 11:12 pm

Yep, the goal of monetary policy is not to stabilize financial markets, it’s to target levels of inflation and unemployment, which CBs can’t even get right.

derek June 24, 2013 at 7:54 pm

I suggest you are wrong. These capital flows happen because of a certain spread of interest rates, a certain risk, all calculated to make a return. The borrowed capital is then invested in something, whatever that may mean. When that flow changes, the capital is no longer invested. That has effects. The nastiest is when the investors go insolvent.

Would it mean anything if this whole structure of debt was predicated on the Fed buying $80 billion or so each month of various securities? That would mean that the Fed has been the driver of this trade.

Max June 24, 2013 at 7:10 pm

I was confused before, but now it’s all clear. Thanks.

Jay June 24, 2013 at 7:56 pm

Off topic but I wanted to point out more proof that Matt Yglesias is f***ing retarded. The 99.996% figure in the title from the link below ASSUMES when the OIG goes in to do an audit its sample is the entire f***ing population. The only way for someone to be more f***ing retard than Yglesias is if the OIG actually conducted an audit of the SSA by choosing 100% of the population as its sample space rather than using the plethora of pedestrian sampling techniques – which are apparently too wonkish for Yglesias.

http://www.slate.com/blogs/moneybox/2013/06/24/social_security_errors_they_re_incredibly_rare.html

dbeach June 24, 2013 at 8:47 pm

Cool comment, bro.

Frank Somatra June 25, 2013 at 1:02 am

You should have stopped after the first two words.

Kamron June 26, 2013 at 6:59 pm

Off-topic, but this wasn’t a random sample by the OIG, this was an audit of all cases where benefits were paid to “individuals whose Numident record contained a date of death”. There were only 2,475 such individuals. You maybe should spend less time asterisk-swearing and more time reading the stuff you’re complaining about, ^$&#*$&@ (rhymes with “plum truck”).

Bill June 24, 2013 at 8:06 pm

I am willing to bet at any moment there is a carry trade going on involving a changing set of countries.

Please tell me a period when there was NOT what someone characterizes as a carry trade going on….this week Japan, next week the US, ….it seems that if you frame “carry trade” as unique, you get a storey….

until THAT carry trade ends,

and the NEXT one someplace else begins.

Perpetual carry trade.

There is no such thing as a perpetual equilibrium.

derek June 24, 2013 at 8:23 pm

You know what a carry trade is don’t you. When interest rates are low in one country, you borrow and invest the money somewhere else where the return is higher, factoring in exchange rate risk etc. The Fed keeping interest rates low was purposeful monetary action on their part. The same happened with the Japanese when they were in their perpetual slump. You need exchange rate stability for any of this to happen.

Yes there is always arbitrage of some sort or another. There is rarely arbitrage structures of this magnitude. The Fed set up a structure that is too big to fail. I suspect we will get a pronouncement this week saying that their optimism about the economy was wrong, and announce another round of QE.

derek June 24, 2013 at 8:30 pm

Further, this is the financial crisis of 2008 not quite finished. The QE and Fed injections of capital into the financial system were an attempt to prevent the collapse of the banking and financial system, and has continued till recently. They were buying mortgage backed securities from financial institutions, helping them out by buying their trash. If someone is going to pay for the trashed house after the last party and keep buying the liquor, why stop? The stupidity of bailing out a financial system is becoming apparent.

This crisis won’t be over until there is nothing left to lose. An addendum to add, as well as no central bank resources left to waste.

Bill June 24, 2013 at 9:06 pm

derek, I do know what carry trade is, and perhaps you should give me some time periods when there was no carry trade anywhere in the world. Perhaps you acknowledged this with your comment: “Yes there is always arbitrage of some sort or another.”

Am waiting for you to identify any period there was no carry trade in the world financial system.

Maybe George Soros has some information on when there was such a stable period without a carry trade, but, then he wouldn’t be making money.

derek June 24, 2013 at 9:57 pm

I’ll ask you a question in response. Were there not always mortgages being issued in the US, and Europe for that matter? Were not mortgage securities issued for a couple of decades prior to 2008? Are there not mortgage securities issued today? So 2008 was just our fevered imagination.

Your statement is meaningless. Scale matters. These things end up being cascading events because of the fragility designed into the systems. The hint of a change in Fed policy changed the risk of the carry trade so large numbers liquidated, which then causes secondary effects. One of them was an almost collapse of the Chinese banking system. The nascent housing improvements in the US will be another victim.

Bill June 24, 2013 at 10:50 pm

derek, Fragility comes from NOT increasing liquidity…just look at the Great Depression. MV=PQ, remember? What happens to V during a during a depression/recession? (Hint: V drops, so M increases>) By the way, what is the demand for money during a recession? See banks lending alot?

Have you seen inflation lately for all your comments about M?

TallDave June 24, 2013 at 11:19 pm

derek: OK, let’s say MBS were a bad choice — it’s still possible to maintain NGDP growth without rewarding/encouraging stupidity. CBs could just change their target, but they don’t, for a variety of bad reasons.

I can’t believe I’m agreeing with Bill. Time for bed!

derek June 25, 2013 at 12:48 am

Mortgage backed securities are fine. Unless you do stupid things with them like the GSE’s and Wall Street did in the last decade. Carry trade is fine as well. It always comes down to scale. The Fed in their goal to get the US economy going has managed to export a real problem to developing countries. The low interest policies and asset purchases have created a huge arbitrage opportunity where insanely the inflationary effects happen elsewhere, and there is a small effect in the country at which it is aimed.

By fragility I mean that an obscure few words that maybe mean that at one time in an undefined future there may be a minor tweaking of some ill defined aspect of some policy or other causes a reaction where there is a 40% rise in treasury rates and an unwinding of a very large amount of trades, with a bunch of cascading effects all over the world.

This is not nothing. China and Japan’s current problems are multiple points of failure with many causes. The fine points of what was the cause or trigger are meaningless because people react. Bernanke signaled that his QE policies may come to an end. The problem is that the structures built up upon the QE policies have become too big to fail.

You are right about liquidity. Bernanke will continue the QE policy because he has no choice. Or more likely he will step down and his successor will be forced to do so, and Bernanke will walk away having saved the world from a great recession. Then he will make some comment some day that he didn’t expect financial people to take free money and do foolish things with it, or something inane like that.

Andrew' June 25, 2013 at 9:54 am

And he’ll have to ‘rethink’ everything he ‘thought’ but not what he did.

leisure guide for vacationing electrons June 24, 2013 at 9:22 pm

If I could hire anyone in the world to spend the next 10 years explaining to me the
difference between carry trade, on the one hand, and reverberations of manipulations by
smarter-than-casino-owner market participants, on the other hand, would I not be as clueless 10 years from now as I am today?

Willitts June 25, 2013 at 10:52 am

If you define having a clue as being able to suck in money like a black hole, then most of us will still be clueless in ten years regardless of who teaches us.

I understand the carry trade but can’t exploit it within my willingness and ability to take risk. Most fortunes begin with large, highly levered gambles. Beyond that you have the liquidity and capital to survive losses. Most of us live life near the felt and we are afraid to lose what we’ve got.

Most of the value I provide to my clients are tax shields, diversification, and free pickups of a few basis points. From an emotional standpoint I get them to stick to their strategy when times get scary. These clients built small fortunes and don’t want to outlive their assets and want to leave bequests.

More generally I’ve got more stories of people who lost everything in finance than those who became super wealthy. I’ve seen fortunes frittered away.

Frederick Harrison June 25, 2013 at 8:12 am

This is just another example of the Powers That Be enriching themselves at the expense of those who can least afford it – the weakest and most vulnerable members of society! Yet even here, there are signs that the worldwide economic crisis is biting (or is it just that they are managing to hide their earnings abroad?). Given that austerity is now accepted to be ineffective and in fact counter-productive in dealing with the economic crisis, maybe it’s time politicians and administrators took advice from professional economic crisis specialists with a proven track record of positive results. For example, the Orlando Bisegna Index, specialists in the economic crisis, have developed a program that has helped various counties with debt problems, business failures and unemployment, thus improving the economic condition of many families. The program has arisen from their development of the Orlando Bisegna Index, a unique index based on 206 diverse indicators that measures the intensity of the economic crisis in the G20 countries and other Euro countries. Given that none of the policies adopted so far seem to be effective in bridging the ever-widening gap between rich and poor…

Willitts June 25, 2013 at 10:36 am

Where can I apply for a job as a Power That Be? I never see it on The Ladders.

JWatts June 25, 2013 at 12:01 pm

You have to get the secret decoder ring and enter in the proper pass word. And I think there’s a special hand shake or back rub or something like that.

Jonas June 25, 2013 at 4:44 pm

The first rule of the Powers That Be is not to talk about the Powers That Be.

Joe Smith June 25, 2013 at 2:05 pm

The scariest part is this: “On Wednesday, aggregate volume totaled 5 million contracts, equaling a notional value of $5 trillion. … The carnage continued on Thursday with volume trading 5.3 million contracts”

So they did five trillion in trades on Wednesday and 5.3 trillion in trades on Thursday. The dollar amounts being traded are out of all proportion to the reported capital of the banks. If there is some sort of liquidity event in these markets (and the article suggests that there are liquidity problems) we could find out that the whole market is one giant house of cards with someone hiding huge losses.

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