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Wednesday, March 30, 2005


the carry trade

building on yesterday's observations, i read through bill gross' march letter again for his ideas on foreign central bank buying, which (as he concludes as well) is "mispricing" the american bond market.

first, the counterpoint:

an interested reader might wonder why our durations and overall strategy appear so defensive. After all, if foreign central banks and others continue to absorb 70%+ of the bond market's new supply (900 billion out of an estimated 1.3 trillion in 2004), why wouldn't this "squeezing" out of domestic investors continue unabated, with yields continuing to move lower? The insensitivity to price/yield exhibited by Asian central banks in an effort to cap their own currencies might seem just as illogical 50 basis points lower as it does right now. And if the lack of global aggregate demand reflected in a surfeit of savings is really the primary cause, the malady is not likely to improve for years.
to which he must acquiesce:

Point granted. We might be at the mercy of a bond market tsunami here, whose first wave has struck and is now receding, only to be followed by more of the same in a few short months. This possibility is part of any interest rate guessing game except it is complicated in this new instance by buyers who have non-interest rate concerns.
but -- and a rather large but:

Still, there are limits. Why would a central bank buy 10-year Treasury paper below 4% if it expected 3-month Treasury Bills to be yielding 3½% by the end of the year? It could cap its currency just as easily by going the short maturity route without risking future price losses. And for those institutional foreign bond holders, and the "hedgies" domiciled in the Caymans, there’s no doubt too that a higher and higher short rate reduces and in some cases eliminates "carry," leading to collapsed positions and ultimately higher yields further out on the curve.
this carry trade grew massive and widespread over the last couple years, as surfeit liquidity combined with a steep yield curve to enable global banks and hedge funds -- stuffed with uninvested capital looking for a moneymaker -- use that capital as collateral to borrow at low short-term rates and invest in higher-yielding investments, including longer-term bonds and mortgages.

moreover, many may have invested in emerging markets bonds for their high-yield sink. spreads (the yield difference between EM bonds and treasury bonds of like duration) are remarkably low, indicating great optimism and/or heavy investment in these riskier assets.

the appeal of this trade evaporates when the short-term borrowing rates (which must be refinanced regularly) rise vis-a-vis the high-yield investment. this is exactly what a flattening yield curve is. for those who have more recently invested in EM bonds in search of yield, it means holding a high-risk asset for increasingly little return -- a return that could easily be wiped out by volatility overseas.

the carry trade wasn't installed in a day. the trade is sometimes difficult to unwind -- especially for those who made 30-year fixed rate mortgages with their yield-seeking capital. that money has been lent and cannot be called. and someone is holding that risk, and no one is really sure who it is.

rising rates should be well anticipated by many. however, inevitably, someone will get caught out in the storm -- and one has to hope that whoever it is isn't important enough to spark a panic. the odds of such a thing happening get greater the faster the fed is forced to move, especially if unpredictably so. as the economist noted:

The IMF fears the bond market will be caught out in 2004, much as it was in 1994. Back then, markets were similarly bracing themselves for a gradual shift to a tighter monetary policy. Short-term interest rates were low and longer-term rates high, in anticipation of the economy reaching full strength. As a result, the "yield curve" at the beginning of 1994 was unusually steep -- almost as steep, indeed, as at the start of this year (see second chart).

Sure enough, in February 1994, the Fed started raising rates. But it went further and faster than anyone had anticipated: seven hikes in 12 months doubled the federal funds rate to 6%. As short-term rates caught up with long, the yield curve flattened out. The liquidity tap was turned off; the carry trade miscarried. Investors could no longer borrow cheap money to lavish on emerging markets. Emerging-market bond yields shot up. The result was Mexico's "tequila" crisis, in which the country found itself with more debt than it could repay and a currency peg it could not defend.

This time might be different. Few emerging markets are any longer in the business of defending unsustainable currency pegs, as Mexico was in 1994. If emerging markets do fall out of favour with foreign investors, their exchange rates can take some of the strain.

The IMF is still worried, however. "Valuations on emerging-market bonds, especially sub-investment grade bonds, appear vulnerable to an increase in underlying US treasury yields," it says. As the Fund points out, the notion that this time it's different has led many an over-optimistic soul to repeat this time exactly the same mistakes he made last time.
the paramount question is whether -- in spite of the massive imbalances in play -- the fed can maintain control of the leviathan and quell the possibility of a market riot predicated on a loss of confidence in the power of the fed. given the inflation data i talked about yesterday, i have serious concerns about their ability to pull it off.

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