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Carrying the World


This is our brave new world of liquidity.


Coordinated central bank intervention has created unprecedented world wide liquidity. Even bulls admit that their case is highly dependent on this liquidity continuing, which they believe will. The disagreement between bulls and bears is then based on one factor: bears think that this liquidity is the result of the break-down of normal macro functions that play to measure and mitigate the risks of capital flows and is therefore unsustainable.

Simply put, bears believe that large market participants are willing to take huge risks, risks that they normally haven't taken in the past, in order to eek out any returns. From pension fund managers under pressure to meet a bogey rate, to large banks and dealers showing high trading profits to offset lackluster returns in their normal business, to hedge funds who have promised returns to their investors and want to keep them happy, all these firms are taking extraordinary risk in one place to get those returns, and at the same time, that place is fostering the world's liquidity on which asset prices are so dependent.

It's the carry trade, and it's simple in its construction and its danger.

A pension fund manager is desperate to make money and investing in safe government five year bonds at 4.75% is just not going to cut it. The bogey rate for the fund of 8% is necessary to earn on its assets in order to fund its future liabilities. If the manager went to his boss and told her that rate was unrealistic, he would be fired. If the rate was dropped the company would have to take a charge to earnings and that is just not an option. So he has to find places like the stock market where he at least has a chance to earn that 8%. Of course the fund could actually lose money on stocks, so the risk is higher that somewhere down the road the problems would be even greater, but it is better to worry about that later.

But the manager has now found a place where he can earn more than the 4.75% yield on the five year and earn it now: he can lever up that yield by borrowing money at a much cheaper rate and buy more of those bonds. It might seem impossible that the manager can borrow at a rate cheaper than the risk free rate of the government, but if the manager can just close his eyes to risk he has found one: other countries' risk free rates.

Swiss government bonds (or Japanese government bonds) are yielding 1.25%. The pension fund manager shorts these bonds and receives Swiss francs equal to the price of the bonds (near par) and pays the 1.25% interest rate to the holder. The manager takes the Swiss francs, converts them back to dollars, and buys government bonds and earns 4.75%. If he does this enough he can earn enough of the 350 basis point differential to equal his bogey rate for the fund. His boss is happy and tells him he is a genius.

There is only one problem. To unwind the trade when it is time a few years from now, the manager will have to go back and buy Swiss francs to return the principal on the Swiss bonds. If the Swiss franc rises, in fact by only 3.5%, all that "interest" the manager has "earned" on those bonds will be wiped out. If the Swiss franc rises more than that the fund will incur more losses.

Amazingly it turns out that if the fund manager wants to hedge against the risk of the franc rising, all those "profits" he expects to earn are exactly offset by the hedging costs. In other words, the whole trade is really a sham: there is no free money and the fund in actuality is taking a huge amount of currency risk.

This is what I meant earlier when I said that the normal mechanism of macro flows has broken down. All through history capital flows occur between countries that account for risks that exist between those countries. The new carry trade totally ignores those risks: participants are bypassing mechanisms and ignoring risks.

This is our brave new world of liquidity. Central banks print the money and investors go for it wherever it is at the moment.

With Swiss and Japanese interest rates near zero those risks are right now illusory. But when these countries eventually begin raising rates, which by definition they will, these risks will become very evident. They will show themselves in massive capital losses from many different participants. This is likely to result in these participants waking up and having to dramatically reduce those risks.

Like a dam bursting, the reservoir of liquidity will end abruptly and will cause credit spreads to open up and asset prices to fall.

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