You’ve probably read a lot in the news recently about carry trades. Many of you may not fully understand what they are or why they matter.
I’ll try to help explain that, but I also want to go beyond that and delve into how central banks enable these carry trades and the broader ramifications of them as policy.
What’s a Carry Trade Anyway?
Let’s start at the beginning. A carry trade, in its simplest form, is when you borrow an asset with a low yield to buy one with a high yield.
For example, if the 1 year German Bund paid 2% and a 1 year US Treasury paid 5%, you borrow in Bunds to buy Dollars and make 3%.
Now, in normal markets, what would happen is the German currency (in this case, the Euro) would strengthen 3% over the year, so that your benefit from a higher dollar yield would be offset by a decline in the currency.
This is what is referred to as interest rate parity (IRP). You, in theory, shouldn’t be able to benefit from different countries having different interest rates.
However, in the real world, there are times when IRP doesn’t hold (usually because the country with the lower interest rate forces its currency to depreciate, rather than appreciate) and you can profit selling a low yield currency to buy a high yield one.
When this happens, traders will view this as a free lunch and try to arbitrage it. Of course, it is only a free lunch until a central bank changes its policy. This is what happened with the yen recently.
Often, traders will push things too far and engage in risk arbitrage. This means they will make riskier bets than just borrowing Bunds to buy Treasuries. They will instead borrow Bunds to buy stocks or options.
This means they have even greater downside if the central bank they are borrowing from decides to defend its currency.
Central Bank Behavior
Central banks set policy by interfering in markets. This isn’t a provocative statement. It is their mandate.
However, they are supposed to have a light touch. They try to set an equilibrium for interest rates that keeps the economy from getting too hot or too cold.
At times though, central banks go too far and do what is call financial repression. This means they intentionally hold interest rates below a market clearing price.
When this happens, carry traders will sell the currency to buy a higher yielding one. This selling pressure weakens the currency, rather than strengthen it as predicted by IRP.
Nearly all historic examples of carry trades are a result of a central bank artificially holding down interest rates and/or seeking to weaken its currency.
Because central banks change policy slowly, investors feel emboldened to take advantage of the carry opportunity, since they perceive the immediate risk as limited.
This creates a potential circular loop where the continued depreciation of the lower yielding currency leads to more demand to borrow it and thus further depreciation.
It also leads borrowers to buy riskier investments, as opposed to another currency, because they are so confident that the cheaper currency has next to zero risk.
Eventually, the pressure becomes too much and the central bank has to change its policy which leads to the type of painful correction we saw recently.
Famous Carry Trades
The most recent version of the yen carry was related to the Bank of Japan trying to keep interest rates near zero while being seemingly unconcerned about how much the yen weakened as a result.
However, yen carry goes back as far as the 90s. Japan has spent decades trying to stimulate its economy through artificially low interest rates. For long periods of time, they did so in ways that also weakened the yen.
Note, carry trades aren’t just practiced by short term traders. Japanese life insurers have been issuing policies in yen and investing the proceeds in US bonds for many years in an institutionalized version of the trade.
There have even been times where you can hedge the currency risk and still add extra yield by buying US investments due to anomalies in the swap market.
The reason the yen carry trade keeps returning is the BoJ tends to change policy very slowly, so it’s pretty easy for investors to front run any policy changes – most of the time.
The other big carry trade of recent times was in the US. During zero interest rate policy (ZIRP), the Fed all but guaranteed corporate credit losses would be kept to a minimum.
This meant you could borrow in Treasuries at zero and buy BBB credit at say 3%. This was even better than the yen trade as there was no currency risk.
Since the Fed had all but guaranteed you wouldn’t lose money from defaults, investors astutely levered up these trades.
Why settle for making 3% “risk free” when you could lever up 5X and make 15%???
This trade ended with the return of inflation, but a lot of money was made for years by using Treasuries to fund all kinds of higher risk assets.
Systemic Risk
OK, so that was a long setup to get to the problems. Let’s start with the more obvious one.
As alluded to, while central banks can distort interest rates for a long time, they can’t do it forever. Eventually market forces win out and the trade ends.
When that happens, everyone rushes for the exits at once, so prices collapse, the leverage gets taken down, and lots of investors get wiped out.
In a worst case, the pain can spread beyond financial markets and impact the real economy. If a large financial firm couldn’t meet its margin calls, there could be large losses at the investment banks who lend to them which could spur bank runs.
But there are also problems before the carry trade ends. While it is ongoing, it distorts prices from reality beyond just currencies and interest rates.
If people are borrowing yen to buy stocks, that means the stocks are trading above a normal market clearing price. When that happens, the buyer is a winner and the person who sold at “fair value” is a loser.
This has lasting implications. When people look at what average stock valuation or credit spreads have been since the financial crisis, they are looking at a distorted data set.
Most of that time period was affected by ZIRP which makes that period not very useful when trying to apply it to the next ten years.
But there is a second, larger problem caused by the Fed suppressing interest rates for so long.
Wealth Inequality
Guess who benefits from taking on leverage to invest in low risk carry trades? The investor class, aka wealthy people.
Guess who doesn’t have the ability to take advantage of a low risk market for investing? Working class people without disposable income.
Thus, carry trades increase the wealth divide.
For all the political talk about income inequality, you never hear a politician talk about Fed policy as the key driver of the growing gap.
If they criticize the Fed, it’s when they keep rates too high, not when they keep them too low.
But ZIRP did more to divide people politically than anything passed by Congress or any executive order.
Ironically, the biggest advocates of ZIRP were the loudest voices about the growing income inequality. Senator Warren and her friends advocated for Modern Monetary Theory (MMT) which basically argued for a permanent carry trade.
MMT suggested there was no cost to unlimited debt financing to increase government spending because interest rates would remain low.
Ironically, MMT advocates often pointed to Japan’s high debt and low interest rates as proof that MMT worked!
Among the many flaws of MMT is that it will always lead to large carry trades that increase income inequality and increase the risk of a market crash.
Managing Risk
So what do you do when you see these carry trades going on?
There’s not a lot you can do. Fighting it means accepting lower returns as history has shown these episodes last longer than people predict.
You can try to participate and take on leverage, but that’s a bit like buying a cat bond because returns were great last year. You don’t know when the music will stop playing so it’s a dangerous game.
The best option is to make sure you don’t have unexpected exposure to the end of a carry trade. While you can’t do much about stocks selling off, you can manage things like not using margin or selling cheap options with unlimited downside.
And if you happen to be a government policymaker, don’t overleverage the country’s balance sheet to keep rates low while not benefiting the real economy!