Weightless Waiting for the Deflation Descent
Submitted By JM
Way-back machines don’t just offer visions of the extremes. They set a framework for understanding reality. Simple pattern recognition can be right or wrong. Combined with logic and human reason it is a powerful way to summon the muse.
If inflation is fiery and vibratory, then deflation is cold and numbing. Get ready for an icy forecast.
Deflation and Carry Trade: Frozen East
A carry trade is a short funding currency-long target currency position that takes advantage of interest rate differentials. Unfortunately, high interest rates typically go hand in hand with interest rate and exchange rate volatility, creating conditions for an unwind crash as the money heads out of risk and back home. A crash in financial terms means that volatility slowly subsides over time and then the spikes in short order. It is like getting drunk sitting down. Standing up when the show is over makes the floor suddenly go vertical.
Mild deflation makes for low interest rate returns and a weak currency, which are the essential ingredients for a carry trade in the first place. Kurtosis and skewness specify the nature of The Unwind.
Skewness shows how symmetric the probability measure is. Options traders understand skew well because it affects the value of buying a call to offset the value of buying a put. Same thing going on here, folks. Using data from the Japanese carry trade, the negative skewness shows the impact of unwind is negative for a number of target currencies from 1996 to 2008.
Kurtosis measures tail risk. Positive kurtosis implies a peaked probability measure and higher chances of an extreme event going down.
Again using Japanese data from 1996 to 2008, you see the currencies with the highest kurtosis.
Combining positive kurtosis with negative skewness is the worst of all possible set-ups but it is its fundamental nature. The combo with the highest return on the carry also has the highest probability of an unwind crash.
Dark Angels Circling Frozen Reflections
There has been much discussion about the possibility of a dollar carry trade. Although I’ve resisted it, it seems pretty clear at this point I was wrong, and there is full-on dollar carry trade. This is bad, bad news for everything else, and I’ve nick-named it The Unwind.
It is the Unwind because the dollar shouldn’t be a carry currency: it is volatile anyway, and that combined with its reserve currency status makes it like playing with gasoline and matches. Wild swings in exchange rates followed by asset markets are often the result of an incremental leveraging and then a violent unwinding carry trade. Get ready for some dollar love that will burst many bubbles and illusions.
The Unwind will initiate the next iteration of debt-deflation. Don’t let the current optimism and propaganda dull your wits: optimism prevailed from 1929 to the spring of 1931. From the authoritative The Crash and its Aftermath:
- By 1931, interest rate spreads declined to their lowest levels since the market crash.
- The Sterling currency crisis drove them to new high levels.
- South American country defaults destroyed the foreign bond market.
- Investment grade bonds collapse. Utility bonds become the premier investment.
Structures From Silence
I selected those bullets (from the dozens available) for a reason. Currency unwinds can be the triggers to pure economic carnage. Emerging markets can literally just give up without a stream of dollars coming in the coffers; if it did this to their bonds markets, what do you think it did to what little equity markets they had? Even high-grade bonds got smashed, except utilities.
There is order in chaos. These events aren’t unique to the United States after the Crash. The Japanese Lost Decade(s) show the same pattern. The Unwind will generate the same in kind if different in degree.
If the United States has to raise interest rates to protect the dollar, it’s all over. If target countries default off bad fundamentals, it’s all over. The Unwind begins like Shiva smiling on Alamogordo.
Beneath the Icy Floe: Post-Bubble Price Convergence
Pricing power and to a lesser extent debt profile is life or death in even mild deflation. Japan’s real estate and rents underperformed the general price level more than 20 years after the event horizon.
Japanese petroleum product prices (distillates and crude quotes) proxy the commodity complex in the Lost Decades, and it doesn’t bode well for the commodity melt-up going on right now. Roughly two years after the real estate crash, petroleum products in Japan saw a hefty spike, and then utter collapse. It took fifteen years for it to recover. We saw another megaspike in 2007 and then implosion. Past is prologue.
Note what outperformed the general price index over the whole time period consistently? Electricity, gas, and water charges. Utilities: the premier investment in deflation.
Eclectic Swaps in Frozen Intervals: Debt Deflation Positioning
Selected CDS are popping already, in ways that make me think their pricing is close to sadism. So I have a lab-works idea: trading delusional recovery rates.
This view is constructed by bundling a standard CDS with a Digital Default Swap (DDS). If there is a credit event over the tenor, the short recovery rate side will profit from buying defaulted debt at a lower price than the implied recovery rate. So if the implied recovery rate on the trade date is 40%, and the reference entity experiences a credit event, buy the bonds on the market at, say, 20% of par. Receive 40% implied notional and deliver the bonds into contract, and net 20% times notional on the trade.
This strategy could be traded on credit derivative indices. Without being too specific, I worked through some very assumption sensitive trade P&L, and the choice is between the anti-alpha (picking single-name losers) strategy and the liquidity benefit of indexing is unclear to me. I likely don’t know as much as some of you do on this issue.
Super-Cooled Bose-Deleveraging Condensates
Don’t expect an economic ice age—such extreme deflation is too dark and troubled to ponder anyway—but do expect years of silent fields and pale winter light. Remember that when snowflakes dance under bleak cloudy skies they are still beautiful when you look at them.