Behavioral Macro

I’ve written a couple of times already about the yield spread between 2s and 10s being an excellent contemporaneous indicator of risk appetite in equities. Macro guys look at a variety of “flattener/steepener” indicators, but this one is the granddaddy. It is something stock-jockeys often overlook.

The downdraft that started in March presaged the April volatility. It is a tribute to market strength that we only got volatility and not a more meaningful sell off.

It is now turning up. It’s worth you while, IMO, to sit up and take notice.

This is the question I always fantasize an insightful CNBC interviewer will ask of his/her guest after the guest offhandedly mumbles something about ‘the yen carry trade’.

Odds are, though, it’ll never happen. 

What is a carry trade and why is it so pervasively misunderstood?

First, a quick bit of history (Quick. I promise).

Back in the mid-90s it became increasingly clear that the BOJ was going to become much more aggressive in the battle against Japan’s deepening deflationary pressures. This unleashed monetary experimentation that eventually brought us concepts like ZIRP (Zero Interest Rate Policy) and QE. Fun stuff.

This produced the following investment backdrop: Japanese rates quickly going to zero, US rates north of 5 percent, and influential economists (including He whose name cannot be uttered) exhorting Japan to induce yen depreciation to reverse inflationary expectations. With this scenario, what was a hedge fund to do? Short the yen against the US dollar. In size.

Not only could you expect yen depreciation, but the large interest rate differential gave the trade a sizable tailwind, or, as fixed income guys refer to it, positive carry. On this position, the yen would have had to move against you (appreciate) 5 percent per year to breakeven. This led, over the 1995-98 period, to a move in USDJPY from 80 to 140. Since the positive carry was a sizable part of the ex-ante total return, it soon became known as the yen carry trade. (Side note: the memory of the move from 80-140 is behind much of the hedge fund community’s enthusiasm for the long USDJPY position today.)

But this yen carry trade was largely unknown outside of practitioners until 1998. Up until that point it was the purview of secretive hedge funds and fixed income wizards. The smart guys. However, that year, triggered by the Russian default, markets saw a disorderly unwind of the considerable risk built up in the previous few. From Russian GKOs to Danish mortgages to NJA currencies, it seemed everything was “funded” by a short yen position. Long-Term Capital Management—and the Wall Street prop desks that saw their trades and copied them for their own books—was at the center of much of this. But many, many others, notably Julian Robertson’s Tiger Management, experienced enormous pain.

The phrase ‘the carry trade’ soon became common parlance in finance. So common, in fact, that these days any time anyone shorts the yen—or any currency with below average interest rates for that matter—it gets referred to by some strategist or equity investor as ‘the carry trade’.

People say this because: one, it vaguely fits people’s memory; two, jargon makes people sound ‘in the know’ like the smart guys; and, three, to the legions of those still consumed by their anger at the Financial World it is laden with all the right pejorative connotations—secretive speculators blowing up our world.

But it is wrong.

Think about it. Who has lower interest rates today, the US or Japan? Right. There is no carry there. How about Europe vs. Japan? Right again. Investors short the yen because they are betting on yen depreciation. Carry plays no role.

What, then, do the pros consider a carry trade? The calculus is really simple. If, when you establish the position, the majority of your ex-ante return comes from the interest rate differential between the asset you short (this can include cash) and the asset you go long, then you are putting on a carry trade.

This implies that the price volatility of the paired trade is low RELATIVE to the interest rate differential.

Example: if you buy the Australian dollar against the US dollar, the interest rate differential these days is about 3 percent. Not a lot of carry. The volatility of the pair these days, while very low by historical standards, is still about 10 percent. This means your return will be dominated by the appreciation/depreciation of the pair, not by the carry. You can say this trade has positive carry to it, but you cannot call it a carry trade.

The classic carry trade in currencies came from the days where many emerging markets had pegged FX regimes and high interest rates—due mostly to shallow financial markets and lack of policy credibility. But those days are mostly gone. There are very few true carry trades left in the currency space. Currency volatility relative to potential carry is just too high. The only real carry trades these days are in credit—like them or not. And with low policy rates and steep yield curves in the main financial markets, some of them are quite attractive.  Carry on!

by Mark Dow and Michael Sedacca

Few would still argue against the assertion that the Federal Reserve has been central to the financial stabilization and economic recovery from the 2008 crisis. They fixed the plumbing and are now trying to incentivize animal spirits to pump water through the pipes. The debate has now migrated to exit strategies and whether growing side effects from exceptional monetary accommodation outweigh incremental benefits.

Nonetheless, it is the Fed, views are heated, and many misperceptions persist. The concept of money printing resonates strongly and intuitively with almost everyone, but most of the intuitive reactions to the Fed’s QE are turning out to have been wrong. Here are some of the major ones that linger.

1. Money printing increases the money supply. The Fed does not control the money supply; they control base money (or outside money), which is a small fraction of the broader money supply. In our fractional reserve system, the banks (loosely defined) control the other 90% or so of the money supply (a.k.a. inside money). And the banks have not been lending. This is why the money supply has not grown rapidly in response to years now of QE.

2. QE is “pumping cash into the stock market”. The truth is little of this money finds its way into the stock market. When the Fed implements QE, they are buying low-risk US Treasuries and agency mortgages from the market, mostly from banks. About 82% of the money the Fed has injected since QE started has been re-deposited with the Fed as excess reserves. With the remaining 18%, banks have tended to buy other fixed income assets of a slightly riskier nature—moving out the risk spectrum for a bank doesn’t mean jumping into equities, especially given the near-death experience that most of them have just gone through.

Of course, not all of the USTs and MBS were purchased from banks. And some of the money does end up in equities. But, really, not all that much. The other big holders of USTs/MSBs who’ve been selling to the Fed for the most part have fixed-income mandates too, and they are also unlikely to take the cash from the Fed and cross over into equities with it.

So, the natural question is why—if the above is true—have equities gone up so much in response to QE? The simple answer? Psychology and misconception.

By taking an aggressive stand, the Fed signaled to markets that “I’ve got this”. The confidence that the Fed would do everything it could to protect our economic downside stabilized animal spirits. Then it slowly but surely enabled risk taking to re-engage. The fact that so many people believe that the Fed would be “pumping money into the stock market” and so many buy into the aphorism “don’t fight the Fed” (notwithstanding September 2007 to March 2009) made the effect that much more powerful.

In short, this largely psychological effect on markets—one that I (Mark) had initially underestimated—bought time for household balance sheets to heal and is allowing fundamentals to catch up somewhat with market prices.

3. QE will create runaway inflation. “Yet” has become the favorite word of the inflationistas. As in, “Oh, it’ll come, just hasn’t yet”. And the magnitude of that expected inflation has been dialed down from ‘hyperinflation’ to ‘high inflation’.

But some continue to hang on. The most extreme inflationistas insist that it is here now and the Fed is cooking the books. The reality, of course, is the Fed has nothing to do with the compilation of US inflation statistics, which is done by the BLS. Moreover, for those who are worried that all departments of government are conspiring against the American people, you would also have to believe the MIT is in on it too. MIT runs the Billion Price Project, a means of testing, using broad-based internet price sampling techniques, the extent to which the government’s measure of CPI reflects reality.

But, there really has been no inflation, even with rounds of QE and interest rates stuck at zero. What we have learned in this crisis has driven home the points that the lending and borrowing that drive the money supply are more sensitive to risk appetite than they are to the price of money.

Is it possible that this will end in a bout of inflation? Yes. But the odds are lower than consensus had been thinking and they are dropping—fast , as inflation continues to be well anchored and people come to understand better how the transmission mechanism of monetary policy actually works.

4. QE is the reason we have high oil/gasoline prices. This very deeply-held view is just as deeply mistaken. As the chart below shows, post crisis/post QE, oil prices on average (red line) have gyrated around 80-90 dollars per barrel with no ascending trend. The ascending trend came well before we knew what QE even was, in the 2002-2007 period. And the most rapid phase of its rise took place as the Fed was raising rates from 2004-2006.

Paying high prices makes all of us angry, and it feels good to have someone to lash out at, but, alas, reality disagrees.

What, then, caused the rise in the price of oil? In brief, the rise of China after it joined the WTO in 2002 and investor allocations to commodities as a “new asset class”, with trend followers, speculators and prop desks front-running the pack. Remember this was a period in which leverage was building and speculative juices flowing full steam.

In any event, it’s pretty clear it was not a result of the Fed and QE.

5. QE has debased the dollar. Good luck convincing people this hasn’t been the case. This is an excellent example of repeating a falsehood until it becomes accepted as true.

Again, roll tape…

This is the trade-weighted broad-dollar average. It, much like the oil chart above, shows all the action took place before QE and the crisis. From 2002 to 2007 the Big Dollar, as currency specialists like to call it, depreciated some 20%. And the fastest depreciation came…that’s right, when the Fed was raising policy rates. Since the crisis the Big Dollar has been roughly unchanged, with gyrations suspiciously similar to oil’s.

Bottom line: Anyone alleging debasement is working from hearsay and priors, not the scorecard. And there are some pretty high-profile people still throwing around the ‘debasement’ word.

In fairness, the Fed did assume that their exceptional monetary accommodation might result in some depreciation of the dollar. But because the US is a closed economy (exports and imports make up a relatively small share of GDP) the Fed felt—correctly in our view—that it should be setting monetary conditions based on the larger domestic economy. And if dollar depreciation were to ensue, so the thinking went, it would at the margin be positive for US growth, as long as the depreciation was orderly.

Why, then, did the dollar depreciate so much in the 2002-2007 period? Pretty much the same reasons as with oil: it was a period of risk-taking, leverage and deepening optimism regarding emerging markets. All three factors led to dollar selling—well before QE ever made its first appearance in the US.

In sum, much of the received wisdom surrounding the Fed and the effects of its actions is misplaced. Through repetition and ex-ante biases, deep misunderstandings have become ingrained in market psychology.

Importantly however, the recent rise in the dollar and fall in commodities suggest that these long-held misguided views are becoming dislodged. There is plenty of risk ahead and the Fed’s task is far from easy or over. But the Fed, for the most part, is ahead of the curve. Make sure you and your views don’t get caught behind it.