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Tuesday, May 11, 2010


consequences of a shift in carry trade funding


Chances are no one will remember where they were or what they were doing on August 24, 2009, when three-month dollar LIBOR traded under three-month yen LIBOR, or on March 5, 2010, when the situation reversed and yen once again became cheaper to borrow. These dates are marked with green and magenta vertical lines, respectively, in the charts below.

The yield inversion of August 2009 was critical for the continuation of the global bull market; not only did it open the much larger pool of lendable American funds up to global yield hogs for purposes of investment and general merrymaking, it opened up global carry trades to the even larger pool of lendable Chinese reserves. The switch in funding for these carry trades had some adverse effects on Japan, including an unwelcome appreciation of the yen and a rise in its sovereign CDS costs.

The return trip in March preceded the incipient move by China to revalue the yuan by about three weeks; this is a coincidence as much as Pearl Harbor or 9/11 were accidents. All previous moves by China with respect to the timing and pace of yuan levels have been choreographed carefully behind the scenes with us, inter alia; those who protest that this is not how things should be run in a democracy are advised to grow up and stop dreaming.

Once the yen became cheaper to borrow, dollar/yuan-based carry trades started to be unwound. Unfortunately, this unwind intersected with the euro’s weakness, and the unwinding of carry trades into the euro zone and related blocs started to feed on itself as these unwinds always do. Put a lot of corn in a yield hog’s mouth and you will be um, amazed, at journey’s end.\

The linkages between the yen carry trade into the euro and global bourses (I love that word. Bourses, bourses, bourses, bourses) became very direct after mid-2007 when global interest rates started their decline toward zero and all assets started to become priced in ersatz money. They weakened somewhat between August 2009 and March 2010 as the dollar became cheaper to borrow, but things have reasserted themselves over the past two months. ...

... [W]hat is going on outside of your window is an unwinding of global carry trades produced by central banks’ collective belief that pushing rates to zero, counterfeiting their own currencies, and encouraging risky behavior is the answer to all problems. Maybe they believe past performance does not predict future results.

beyond driving the value of the dollar as the currency was first sold heavily on the international market to fund the trade, tapping much larger reservoirs of funds sparked a huge second leg in emerging market risk assets. for example:

the yen too is clearly driven by the carry trade, and was in process of funding a heavier share of it when the eurozone contagion exploded.

the transfers of funding in these trades clearly take time, and both currencies fund risk asset purchases. but what the expansion of the trade to dollar funding, first with the arrival of ZIRP in the US and then the yield cross described above, also may mean is that the unwind in progress has further to run, possibly much further. the exuberance of both USD and JPY in recent days hints as much -- both currencies fund quite a lot of third-market assets, and the carry trade is far larger than it ever was or could have been when it preoccupied me prior to 2008.

it's also clear that large traders -- see red lints in COT data beneath currency charts -- anticipated these shifts in carry trade funding and positioned accordingly.

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is there anybody out there?

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