Graphite here.
One development which has been making the rounds in the financial news lately is the development of a US dollar carry trade. I won’t ponder the details of the carry trade here, as I’m sure most readers are familiar with its mechanics. Shorting low-yielding assets like the dollar to fund purchases of higher-yielding ones — which is just about anything besides the dollar these days — doesn’t take a whole lot of work or talent or luck. All it really takes is a lot of that classic elixir of speculation, leverage.
Less interesting than the character traits of carry traders, though, is the spectacular and totally unforgiving fashion in which their speculations can come to grief. Throughout the bull market of the 2000s, AUD/JPY was the king of the carry trades. (Take a look, for example, at this Investopedia article touting the dazzling 83% gains from 2000 through 2007 in the pair.) With the Aussie dollar yielding nearly 600 basis points more than the Japanese yen, the cross pair was an absolute cash cow. As long as risk appetites remained robust, this trade proceeded in a virtuous cycle: its profitability attracted new JPY shorts, who drove the yen further down and made the trade still more profitable.
Then came the financial crisis, and suddenly the carry traders found themselves all leaning the wrong way in a very crowded trade, in a market with leverage as high as 200:1. The chart tells the tale:
Source: Interactive Brokers
From July 2008 to January 2009, nearly the entire 2000-2008 bull move in AUD/JPY, from a low of 56 to a high around 104, was retraced. “Puking” doesn’t begin to capture the desperation with which longs exited this trade.
Earlier this year and a couple hundred S&P points ago, I had been somewhat dubious of EWI’s forecast for the next move down in equity markets to produce a VIX print higher than what was seen during the crash of October 2008. In the 1930-1932 period, the long, steady march down to the ultimate low never really matched the drama of the Great Crash.
However, the development of a dollar carry trade in risk assets shows that complacency and yield piggery, remarkably enough, still reign supreme in the minds of investors. The lessons of 2008 have been quickly unlearned, and its sickening drops in asset prices are now written off as temporary “liquidation events” unlikely to return for an encore performance, especially with the all-powerful U.S. Treasury and Federal Reserve backstopping everything with a wall of “free” cash.
If financial companies are truly protected by an unassailable wall of cash, why are they asking to borrow it from depositors at rates far above LIBOR? Here are just a few of the solicitations for cash I’ve noticed in the past few days:
Contrary to a common misconception of the Fed’s liquidity injections, money borrowed at 0% is not “free.” At some point, traders must liquidate their carry trade-financed assets to obtain the cash to repay the principal balance on that borrowing. In the meantime, those assets had better keep going up in price, or they find themselves in the position of upside-down and potentially distressed sellers. The instability of such trades, and their susceptibility to even the slightest downside shocks in prices, are obvious.
I doubt that anyone is buying stocks with 200:1 margin these days, but if carry trade dynamics are now driving global asset markets, this could presage an eventual explosion of volatility and liquidation of the sort usually only seen in the forex and futures markets.
