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 health, 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