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Guest Post: Understanding The Global Risk Carry Trade
Submitted By TimmyM
Understanding the Global Risk Carry Trade
Many investors are perplexed by the global macro environment and all the mysterious drivers of the equity, fixed income and commodity markets. The analysis of traditional domestic economic fundamentals appears to be less relevant to understanding financial markets. Central bank liquidity policies as used in modern markets has created artificial pricing mechanisms. Interconnected global electronic trading capabilities, central bank sponsored liquidity, largely unregulated derivatives markets and the availability of unchecked trading leverage are now implemented on a global scale as a dangerous market side effect of misguided Keynesian monetarist policy.
Central banks ultimately answer to global money center banks as their shareholders and board of directors. To assume central banks act in the interest of public policy is a mistake. To accept that the health of money center banks, as protected by central banks, is good public policy is similarly misguided. In the world of decades past where most credit was supplied by bank balance sheets and where global electronic trading, money and leverage were not wide spread, central bank liquidity played a more direct role in economic stimulus. The present financial system merely games reflationary policy to the ultimate affect of unstable markets. Money center banks and global investment banks no longer primarily execute their role in the capital formation process. They finance trading, charge fees for trade execution, charge advisory fees and trade for their own accounts.
The decades long central bank policy of promoting credit growth as an instrument of economic growth is short sided. Growth of credit in the U.S. over the last few decades has way surpassed economic growth. Household credit must be serviced by personal income, corporate credit must be serviced by earnings and government credit must be serviced by taxes. To the extent all these sectors of credit grew at unsustainable rates relative to economic growth we artificially propped up economic activity and asset values. This credit growth was an inflationary policy. It masked the deterioration of fundamental economic weakness. It allowed for the U.S. to postpone the market discipline pending before us from unaffordable military and domestic spending. It allowed us to create the illusion of a materialistic quality of life founded on unsustainable borrowing.
Since 2007, an incremental dollar of credit growth no longer resulted in a dollar of economic growth. This is the ultimate failure of Keynesian monetarism. The credit bubble is over. Unsustainable asset values and massive true excess capacity overhangs the financial system. The present central bank zero interest rate policy (ZIRP) will not lead to a credit growth that can stimulate the economy. ZIRP is the funding tool for global risk asset speculation. The two ZIRP currencies of the dollar and the yen are now funding currencies for the global risk asset carry trade. ZIRP is also a massive subsidy paid by savers and retirees to fund asset speculation.
Most observers of financial markets are familiar with the traditional fixed income carry trade. A financial corporation, hedge fund or sophisticated investor would either arbitrage the yield curve and/or the credit spread. Borrow cheap overnight money to fund long term assets or fund higher paying risky assets. The present global investment scene is now dominated by a cross currency funding of all kinds of assets. This strategy of funding in dollars and yen has an implicit assumption that the ZIRP currency will remain weak. To the extent the funding currency declines it actually provides a negative interest carry cost. The growth of leveraged speculators in the global risk asset carry trade over the past few years has now caught the accounts short a massive amount of funding currency.
The global speculators now fund the price support of all kinds of “risk assets”. This includes U.S. Treasury bonds, foreign bonds, corporate bonds, stocks, commodities, real estate securitizations, credit default swaps and a myriad of other trading strategies. In the context of sovereign risk events this global speculative environment is very unstable. Global speculators are now caught short their funding currencies and forced to unwind as these currencies appreciate.
Unsustainable government intervention in economies has now reached its limits. The European crises is a symptom of Keynesian disease. Government backstops of private risk through bailouts and guarantees are ultimately tested by Mr. Market. The handing off of the private sector credit bubble to the public sector is showing strains. The weaker sovereigns are the canary in the coal mine of sovereign risk. Continued government intervention in the natural credit bubble liquidation process will ultimately force all sovereigns into default. The deflation of the liquidation process is a better public policy than the eventual default of U.S. Treasuries. Let the creative destruction process begin.
Given that the worlds central banks answer to global speculators and their money center bank/investment bank sponsors, the people of each country must stand up for a public policy that benefits them. Central bankers have many complex tools in which to exercise their “stability” agenda. While things like currency swap facilities sound harmless when explained as short term in nature, the ability of a central bank to reinstate them at will is a perpetual back stop to global risk asset speculators. When we are asked to fund the IMF in the name of global economic stability, we are really just allowing the sovereign risk hot potato to be passed up the credit ladder in a hidden backstop of foreign folly.
The unwinding of the global risk asset carry trade is the ultimate end game for decades of Keynesian lunacy. A credit bubble cannot be cured by more credit. We must recognize the widely accepted fallacies we have lived by, and devise an exit strategy that is fair to all.
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of course, for the bankers, "fair to all" means that they take the loot.
Unwinding global risk asset carry requires admitting that the reflation scheme has been an abysmal failure.
Politicians and CBs don't play like dat. They prefer to fail and place blame on unforseens. " No one knew at that time...."
<<<<It allowed for the U.S. to postpone the market discipline pending before us from unaffordable military and domestic spending. It allowed us to create the illusion of a materialistic quality of life founded on unsustainable borrowing.>>>>
To say nothing of the fact it allowed the US to deal in idealism and globalization. The real loser when the US faces reality will be the third world and communist thugs.
Yes! ZIRP means Granny is subsidizing Wall Street speculation and leverage. Simple. That leverage is why the market is ONLY being played by the HFT's and Da Boyz under the directed supervision/instruction of the Treserve, and is why it is essential that they keep it propped up. (Nobody will carry trade unless there is a hope that you can speculate successfully with Granny's money.)
Summary: The system requires ever-increasing leverage.
Herein lies the problem: There is no exit. The entire economy is credit. You can't "back it down a little". There is only a circular vortex to oblivion as margin calls continue to take out ever-bigger-dominoes.
The reason it is "Keynesian lunacy" is because it is a one-way roach motel: The system is specifically designed so you can grow credit, but you can't shrink it. Shrinking doesn't mean the system is "broken" ... No, shrinking means the system is GONE. Banks gone. Currency gone. Nations gone.
We're looking at a planetary "reboot" to a new system, although it's currently unclear the terms of the new system. I expect Greece will show us the way. ;-)
Welcome to the Hotel California
Inferno: "Who has destroyed the colony -- who?!"
Megatron: "He is the one, the Maximal, destroy him!"
Inferno: "You will burn, Maximal!"
way off topic
(Bloomberg) Toronto Police Arrest Man With Weapons in Vehicle Near G-20 Security Zonehttp://www.bloomberg.com/news/2010-06-24/man-arrested-outside-of-toronto...
“At 1:04 p.m., officers conducted a traffic stop on a vehicle at 45 The Esplanade,” Vella said. “An array of weapons and hazardous materials were seized,” he said. The items included a chain saw, axe handle, sticks and fuel containers, said Nena Snyder, a spokeswoman for the Integrated Security Unit for the G-20 summit....reported a 53-year-old white man was arrested after his silver Hyundai with an Ontario license plate and topped with a large box was stopped, citing police."
sounds to me like they nabbed themselves a real Canadian Lumberjack - nice how a chainsaw, axe handles and sticks are now classified as a weapons
That's exactly how i read it! If they held G-20 down in Texas, the entire state would need to be arrested with the crap we haul around on an everyday basis.
Spent shell casings find their way into every nook and cranny and there's not much you can do about it. And what would they think of our very loaded Sigs, Glocks, S&Ws, and Kimbers, not to mention AR's and SKS's? There's a lot of stuff besides politicians that needs shooting, but they think it's all about them. It ain't.
I know. Really.
Felling firewood is the new homegrown terrorism.
Don't want this guy procuring any energy for himself outside government channels now.
Yes, he got caught with the WMD's but, luckily, was able to eject the Wagner cd he was listening too and throw it out the window.
The problem with letting it blow sky hi is that TPTB will not only be well fortified against any and all collateral damage but will, when the dust clears, be right there with the next iteration of this!
"...and devise an exit strategy that is fair to all."
Have you been talking to Obama?
To quote Helia James "the only thing fair in life is bus fare". None of what happens is going to be fair. There is no "fair" anymore. Never been such a thing either. What the "new" will look like when this massive collapse is over depends on so much. Wonder what would happen if the citizens of 4 of the states bordering the GOM just did a massive Jim Jones kool aid party and checked out? Most people there have lost all hope and are just "waiting until the end" as they say.......Alternative scenario - everyone just leaves said four states - abandons ship. Massive diaspora. Does the UN help refugees in the US? Probably not. IT is so obvious that some people really want to see some massive population reduction. We don't matter. Get it? Got it? Good. Collateral Damage, Murder, whatever you want to call it....just collateral and not the financial kind. I do know this - a whole lot of very rich people I know do not have underground bunkers or food - lots of cars and land that is now worthless, oh and Gold that you cannot eat but they would not last five minutes during total societal collapse. I like Earth but it is way too dirty now. And impossible to clean up at this point - and all that that implies.
I'll bet there's a LOT of office space in D.C. Kinda poetic if folks become squatters in the Federal Reserve Building!
Who is TimmyM? I would like to ask him if the destruction of the sovereigns is a plan to wipe clean all coming "entitlement" obligations of the OECD countries? That can be the only explanation of why the western CB are so reckless in their behavior.
But if this is the case then what will be considered "money" when the end is done and who will own this money?
Maybe the western CBs are not afraid of one world government? Is the IMF plotting to replace a failed Euro with a new world currency?
Another key support to what I've been labeling The Double Whammy Economy. That's to say simultaneous deflation and inflation all as a toxic by product of Keynesian lunacy.
The deflation part should be self-explanatory by now. It's the natural by-product of a burst credit bubble. It happened during the 1930s and more recently in Japan. The spectacular real estate bubble has taken the spotlight but in truth deflation began creeping in long before. It began in the 1980s when supply-side monetary and fiscal policy took dead aim at middle class income growth. Policies such as de-regulation, union busting, repeal of consumer interest deductions, capping IRA contributions and fostering the growth of Chimerica (with its massive outsourcing and overcapacity) have led up to this day. And it all spelled deflation for US incomes and even US employment levels which crossed a critical threshold of insufficient job creation during the last expansion which never replaced jobs lost during the prior recession. There was only one answer to the conundrum: if incomes shrink how do you sustain growth? Answer: by ramping up credit growth massively.
So add to an inherently deflationary income environment a giant credit fueled stock market bubble and a real estate bubble. Life in America became essentially unaffordable to the average person. Only more and more credit could allow average Americans the feeling that they were not getting poorer year by year.
The by-products of the massive ramping up of credit are all inflationary. But there are specific aspects to the type of inflation. Incomes don't get reflated because they are too far down the liquidity food chain. Employment levels don't get reflated for the same reasons. Residential real estate is also too far down the line and dependent on incomes and employment as a prerequisite (except in 2004-6). Specifically, the global CB reflation policy has a predilection for short term assets and liquid assets. Hence the spectacular rise in commodities, stocks, derivatives, junk bonds, carry trades and the trading environment. This unfortunately is conducive to rising cost of living and doing business which could kill the middle class and small businesses. Crude oil today in the midst of a supply glut and a globally depressed economic activity is at the same levels as in 2006 near the peak of the last expansion. So are copper, palladium, soybeans, cotton, and others. Some are now above the levels reached during the last expansion. Certain fixed costs of living are now in a marked state of relative and absolute inflation such as education, health care, home insurance, municipal services and las but not least taxes.
Traditional metrics such as CPI and PPI don't reflect the state of relative inflation because economic activity remains depressed. In that situation prices standing still represents relative inflation as the value of real assets, real incomes and employment tank. Such a situation is even worse than the prospect of outright deflation.
Yeah, no. Life didn't get less affordable in the 1980s. Life got better. The problem is that with the magic of cheap credit, people leveraged against their getting-better life to buy a getting-even-more-better-er life. It's like the Mexican Miracle of the 1960s. Mexico really *did* get richer in the 1960s, but it overborrowed against its newfound wealth, leading to eventual collapse of the peso in the 1990s.
The problem isn't that good times aren't really good times. The problem is that with central banking and low interest, people fool themselves into thinking good times are a good reason to borrow tons of money.
+1. Although I generally agree with Caviar's posts, there are some differences I have with this one. The "union busting" of the 80's was well deserved and long overdue. GM went bankrupt for a lot of reasons (especially due to moronic management) but I am safe in saying that the unions contributed more than their fair share to the destruction of that company. You can say the same for the steel industry, the airline industry and now, state and local governments.
It is a basic rule of economics that people will do anything to defend their standard of living. So when we faced the competition from other countries' goods and services on all fronts, rather than batten down the hatches and compete, we voted ourselves the right to borrow in an unlimited fashion. Let's face it. No one held a gun to anyone's head and made them buy that house they could not afford, lease that BMW they did not need, buy that second iPod, etc. We did it because we liked it. It is fine to blame the banksters and their ilk. They are all scum and we can agree on that. But we all had a hand in creating this mess and "union busting" was the least of the problems. And BTW, the removal of the deduction for consumer interest expense made borrowing MORE, not less expensive and it obviously didn't change a darned thing.
"It is a basic rule of economics that people will do anything to defend their standard of living."
Which means that in the face of disruptive challengers and creative destruction, the people associated with any given industry will turn to the government to protect it. And it's not like there's no manufacturing in the USA. Quite to the contrary, there's plenty of manufacturing here--but it's all south of the Mason-Dixon, where governments haven't intervened to push wages above what they're worth. If it weren't for right-to-work in the South, we'd be much worse off. The Detroit jobs would still be gone, but Honda, Toyota, Hyundai, etc would be making their vehicles exclusively in Canada and Mexico.
Let me summarize TimmyM's post for those of you who didn't read the whole thing: "Mises was right."
One of the best, plain language synopses of the current situation.
Timmay!
Nice review.
TimmyM, great stuff. But one world government is not rising out of the like of IMF, Central banks, OECD, and whatnot. Even lots of V (for Vandetta) acts with lots of collateral [damages] will not do it. An asteroid hit or pole shift might do it. That will clean up the GoM and all the dirts we created on this planet. I am not a communist nor an OH! Bama fan. But I still have faith in humanity. Way off. Sorry.
I made no predictions, was just trying to suggest some motivations. If the motivations are true, we will need people like you to stop them.
Most vulnerable in the unwinding carry trade will be the long AUD positions. The next move of the RBA in Australia will be down!