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Minyan Mailbag: The Carry Trade Unwind


Every credit cycle ends with the bankruptcy of the largest borrower.

John -

Could you comment on how you see the carry trade unwind is currently unfolding; how far along we are, the current effects vs. expected effects, the probable outcomes as we move forward in time?

There are a lot of puzzling relationships as short-term rates have risen. The dollar strength from short-term US dollar-denominated loans being retired as costs rise would make sense. But if so, how much is left to unwind? Was the carry trade limited to foreign bonds? If not, why have we not seen more selling in equities, US bonds, and commodities? Is the unwind really very muted? (And many carry-traders are holding their trades in spite of more expensive US debt expecting that a weaker dollar will ultimately more than compensate for the rising borrowing cost, and Japan is actually fueling the dollar's recent strength?)

If the unwind is really fueling the dollar I would have expected more upheaval in the process.... I feel like I am staring right at something obvious and not seeing it.

I don't expect that you will have definitive answers for these questions, but am very interested in what your working thesis might be.

I always highly value your insights.

Minyan Jeff


The emperor had no clothes as everyone stared at him; it only took a few to speak up for all to suddenly see.

And we are starting to see only a few speak up where the internals in stocks and the flattening of the yield curve are only tidbits of the endgame. The unwind of what has been building over the years will not only involve the "carry trade", but something much more.

The undwind process could be a crash, but it also could take the form of several crashes or even a cancer like stealth.

The concept of the carry-trade is a massively nebulous one; it can involve something as simple as borrowing short duration and lending long or it can be massively complex, taking the form of complicated derivatives transactions that involve the same underlying concept of borrowing short and lending long. The point is that the carry trade in and of itself is not 'responsible' for action in the US dollar (recall that the FX market is trillions of dollars in size and involves lots more folks than speculators trying to game a few weeks/months' movement) any more so than it is responsible for 'action' in the bond market, which is the second most liquid market in the world.

Determining the 'unwind' from a carry-trade is near impossible; there are simply way too many moving parts within each market (US dollar-denominated bonds, Euro-denominated bonds, dollar f/x rates, US equities, etc.).

The larger point is this: (1) massive amounts of credit have been created out of thin air in the last 3, 5, and 8 years; (2) massive pyramiding on top of that credit has taken place thanks to the increasing risk appetites of: banks (commercial and investment), pension funds, insurance companies, mutual funds, hedge funds, etc. creating trillions (notional) of dollars of derivatives that are held on almost every balance sheet in the world: government, state, local, corporate, and consumer) either directly or indirectly.

This credit explosion took place precisely because (1) the risk-seeking behavior underlying it was booming and (2) the credit printing presses of the major world banks were running overtime creating more and more moral hazard and propelling that risk-seeking behavior to ever-higher levels. A positively sloped yield curve where one COULD borrow short and lend long was thus just the method by which this risk-seeking behavior and credit-creation mechanics of the central banks manifested.

The narrowing of the long/short spread (the 2/10s) has implications that are completely impossible to quantify. All we can do is qualify them by providing you the context above, knowing that by the most conservative measures, the credit outstanding dwarfs the size of the economy.

The unwind of all that risk-seeking behavior, all that credit-creation by central banks, of all those borrow short-lend long trades has barely even started. The first signs are the flattening of the yield curve as faint attempts are made to reduce risk.

The cracks in the façade are beginning to emerge: the global liquidity situation, which we watch closely, is very, very shaky and suggests that we are just NOW entering into a region where the default risks of some of that borrow short-lend long behavior are growing extreme.

One of the oldest sayings in the bond market, long since forgotten post 1998, is this:

Every credit cycle ends with the bankruptcy of the largest borrower.

We aren't even close to that yet.

John Succo
Scott Reamer
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