Understanding the "Carry Trade"

06/18/2004 12:00 am EST


John Mauldin

Chairman, Mauldin Economics

In the media's coverage of Fed policy, we often hear about the "carry trade". Here, John Mauldin, hedge fund expert and author of the recent bestseller, Bull's Eye Investing, explains the carry trade, and its implications for interest rates and the stock market.

"The carry trade is a result of borrowing at ultra low short terms rates and then investing in longer term instruments with higher rates. As a result, the entity that placed the carry trade can then 'make the difference' in the coupons. Hedge funds have been some of the prime beneficiaries and users of the carry trade. Knowing that the Fed was committed to keeping rates low for a ‘considerable period’ of time, hedge funds, major banking houses, active managers, and corporations borrowed at very low rates to invest in all manner of investments: longer term bonds, foreign bonds and currencies, commodities, derivative debt, etc. Corporations swapped out long-term debt for short term debt.

"First, a few thoughts about the risk to world markets caused by highly leveraged hedge funds as interest rates rise. In March, the markets only thought that the Fed would raise rates by 50 basis points by the end of the year. Count me in that group, as I did not think the Fed would raise rates until after the election. Hedge funds and the groups mentioned above, although their hands were on the trigger, were enjoying the nice spread. Life had been very good for some time and Sir Alan was their best friend. Except that Alan and crew started giving speeches warning about inflation and hinting at the end of low rates. This was a blatant move to get hedge funds to begin to unwind their carry trades. It worked. Then employment started to pick up. Economic numbers continued to look good and a whiff of inflation began to actually appear on the world scene. The facts changed, and the very real suspicion that the Fed would start tightening became the theme throughout the investment world.

"Now, the markets are pricing in interest rate hikes to begin shortly and a full 175 basis points by the end of the year. Fed members are still using words like ‘measured’ and ‘patient’ when they talk about hikes, but they are clearly letting people know they are ready to begin the rate raising cycle. Recent employment numbers were quite good. It has been my contention that the Fed would not raise rates until either strong inflation or solid employment numbers (or both) were evident. Now they are.

"Nearly everyone agrees that the ‘natural’ rate for Fed funds should be between 3% and 4%. Anything less is still stimulating the economy. Such an environment encourages more inflation and is boosting the economy. Normally, when the economy is growing as well as it is now and inflation starts to come back, the Fed starts to tap on the brake pedal to slow things down. A rate of 1.5% or 2% or even 3% in an economy growing 4% with well over 2% inflation cannot be called putting on the brakes. 25 basis point rate increases are very gentle tapping indeed. Why would the Fed risk a return of inflation?

"A number of bearish observers have written that they expect a financial crisis, if not a meltdown, to result from hedge funds and investment banks all procrastinating and then trying to exit their carry trades at the same time at the last minute. And indeed, if that were the case, we probably would see a crisis. But my conjecture is that the unwinding of the carry trade is in process. The funds that have made so much over the last year on these trades are now paying the price to lock in their profits. Thus, the speculation that drove commodities and all manner of investments to overbought levels is being driven from the market.

"Greenspan and Company recognize that they created the carry trade. It was a side effect of their desire to stimulate the economy with lower rates. They also recognize the dangers of those trades unwinding too fast, causing deep losses and therefore requiring margin clerks, who have neither soul nor mercy, to force funds and traders to sell in order to meet minimum cash requirements. The carry trade is so massive that the fear is that a too quick retreat could create a cascade. Think Long Term Capital Management. Thus, Greenspan began to send clear signals in late March. By mid-April the unwinding had begun and is still going on today. Overall, it has been orderly, although some traders have not been happy, there are no major disasters surfacing and so far we do not see a lot of abnormal pressure in the markets.

"Greenspan (and to be realistic, so do you and I) wants to see this process continue to be orderly. Remember his speech of last August? The first rule of central banking is to avoid taking major risks. The small risk of a cascading implosion in the unwinding of the carry trade is nowhere near as great as a little extra inflation that can be dealt with later. Thus, I think the Fed will raise rates slowly until they perceive the dangers from this unwinding are gone. At that point, they will start to raise rates in earnest, 50 basis points at a time. But when will this be? I do not think it will be as early as August. Maybe not even this year. But then again, if the process continues apace, perhaps they can indeed raise rates faster, getting us closer to that equilibrium level.

"And perhaps (repeat perhaps) that explains why the money supply is rising at levels usually associated with severe problems, like 9/11 or the summer of 1998. It is just another form of insurance that the carry trade will be unwound in an orderly fashion. As liquidity is being taken off the table in one form (the carry trade) it is being added by the Fed in another. I should note that I do not see the dire predictions of some who think the recent (admittedly large) rise in the money supply herald the end of the world. In reality, we are playing ‘catch up’ for the reversal in the growth of the money supply last year. In a year-over-year basis, taking into account both periods, monetary growth is not all that large for a period of economic growth like we are currently in.

"I have maintained for some time that the Fed will allow inflation to increase more than most observers now believe. I also believe they will work to bring it back down. The end game is whether they will be able to do so without causing a recession. The question is whether they can raise rates fast enough to keep inflation from becoming a real problem without also risking a problem in the markets from the unwinding of the carry trade. It is a delicate balancing act. I can envision a scenario where this happens, but it requires a lot of good things all happening in concert. There can be no hiccups or bumps from a lot of problem areas, such as the trade deficit, the US budget, consumer spending, currencies, etc.

"We tend to forget that only four years ago, short-term rates were 6.5%. An eventual rise to a mere 4% is certainly likely. What does the dual combo of rising interest rates and inflation do to the stock market? It is not pretty. When the market begins to perceive real inflation and a significant rise in interest rates, you do not want to be naked long the market. Until then, maybe. And it may take a long time for that perception to actually come about. But just as the unwinding of the carry trade started quite rapidly and continued, albeit behind the scenes, the return of the bear market will be quick. Keep your hand on the trigger."

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