The Carry Trade
I think that ninety percent of people would agree with that definition before the comma, only ten percent after the comma. The part before the comma is what drives an economy to higher growth, the part after the comma is what gets an economy into trouble.
And this is why Mr. Greenspan purportedly sees nothing wrong with what is going on, while I (and several others) see much.
The Fed has kept interest rates artificially low for some time. This has forced a mis-allocation of assets as people have had cheap money thrown at them, and having nothing to do with it, have bought risky assets from stocks and bonds to commodities with it, desperately searching for a return.
As Todd has pointed out, at the first whiff of higher rates, like a whiff of smoke in a crowded room, people exit quickly. You get a "throw the baby out with the bathwater" effect as all assets go down in tandem.
An example of a carry trade can be as mundane as refinancing a mortgage (borrowing low) and buying a car with it. The car is an asset whose performance can be looked at as a return. The car buyer could not afford the car when rates were higher, but at the current cost, she can rationalize the benefit. When rates go up, the car buying stops.
And of course, people can buy stocks instead of cars.
Another more complicated example would be what a bank does. A money center bank will borrow money from the Federal Reserve at the Fed funds rate and lend that money out to other banks, corporations or individuals at higher rates. The larger the difference between the borrowing rate and lending rate the better. There is nothing wrong with this on the face of it; it is when risk is underestimated that trouble begins (the part after the comma).
As the rate differential lasts too long, corrective forces are postponed and they build up. The whole process of low rates and excess liquidity bids up asset prices, as we have seen. Banks lend on asset prices used as collateral (see Collateral Damage) and when asset prices rise, they lend more and more money. When asset prices then fall, the banks' collateral falls and bad things begin to happen. This is the right side of the comma: the banks are not accounting for the fact that higher asset prices can subsequently drop.
A very complex example of a carry trade could be conducted by international financial institutions of various sorts (hedge funds or large investment banks) where they borrow money in foreign currencies to lend in another currency. This happened in the mid 1990's (and ended badly in October 1998) when Japanese rates were much lower than U.S. rates. Hedge funds were borrowing money in yen (short yen) and buying U.S. treasuries (long dollar), earning around a 4% spread. When rates began to drop in the U.S. and the dollar along with it, this trade fell apart quickly. In one day in October of 1998 the dollar fell nearly 10%, making the 4% spread earned rather paltry in comparison.
In the large carry trades that are out there, we don't think there are currency implications like there were in 1998: rate differentials around the world are much smaller. Most of the carry trades are in U.S. dollars as the Fed has kept short term rates much lower than long term rates.
Carry trades are an essential part of the financial system. It is when, like anything else, it gets to extremes and risk is underestimated that things get ugly. There is always risk.
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