Carry Trade

By now everybody knows that only a last ditch intervention by the G7 prevented the financial system from imploding three weeks ago, when the Yen carry trades blew up in the face of all those who had been short yen, long high yielding currencies. The result would have been a pervasive trading desk annihilation, possibly on par with that experienced after the Lehman collapse had the world's central banks not stepped in to sell Yen in droves. Yet what fewer know is that when it comes to funding cheap carry-type trades, the FX carry trade is merely one. A possibly far bigger one has been the one established courtesy of the Fed's generous Interest on Overnight Reserves (IOER) rate which being far higher than General Collateral (GC) Repo, presents banks with Fed deposit access, what was a sure way to earn guaranteed money on an interest rate arbitrage spread. For nearly two years banks collected the proverbial pennies in front of the rollercoaster... until last Friday, when the FDIC decided to spoil the party. What happened as a result of the FDIC's decision to establish an assessment rate which spoiled the arb, was a blow out for most institutions playing the IOER-GC carry trade leading to a major disruption in this funding market, possibly far more serious than the FX carry trade unwind, and a plunge in overnight GC repo rates on Monday (see chart) by over 75%! Does this mean banks have lost one key carry funding source? So it would appear. And it only means that the FX carry trade will be that much more a critical source of "risk-free" income for banks... At least until the next major earthquake above the ring of fire. In the meantime, as the Fed scrambles to restore normality to the repo market, will the Fed be forced to do Reverse Repos, which while fixing the carry trade, will withdraw far more liquidity form the market. Which as we all know is grounds for immediate incarceration in a Centrally Planned kleptocracy such as the USSA.

While everyone is staring in disbelief at the USDJPY, the real carry action is in the high yielding-YEN pairs, i.e., the development, high growing countries. And it's a massacre: ZARJPY, NZDJPY, AUDJPY - all are plunging far more than the USD. This is nothing short of a complete carry trade unwind. The implications: the cheapest recurring source of funding for risk assets - the Yen carry trade, is over. Those who managed to sell early on are lucky. The rest will get such an onslaught of margin calls tomorrow they may need to access the discount window (if Primary Dealers and the luckier banks). Many will be forced to sell assets to satisfy collateral requirements as ongoing sales of carry pairs push the Yen ever higher, and force ever more liquidity out of the market. And if the Yen carry trade is done, the question is when will the USD, which has also been a carry currency for some time, follow suit. And, once again, the most troubling observation is that the BOJ has not intervened. Our sinking feeling is that after pumping 50 trillion or so in money markets, the petty cash may be running quite low. In any case, ES opens in 2 minutes. Grab the popcorn now.

After it became fashionable to say one was short the dollar at cocktail parties, the net result was a surge in CFTC-reported spec USD gross short positions and a plunge in net USD exposure. And since options traders are nothing but momentum chasing lemmings the theater is now fully on fire. Granted, while some of the recent spike in short interest has been covered, there are still just over a whopping 7.5k contract shorts that need to be covered before a reversion to the recent trendline. This is why we are currently seeing a massive unwind in the dollar short carry trade, and why once again rumors that macro funds are slowly and quietly receiving billions in margin calls behind the scenes.

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.

The cable is plunging: after flirting with 1.50 as recently as yesterday, GBPUSD is taking major stops out and just dropped below 1.47. Next stop 1.44 as the physical gold and silver shortage is sure to take the UK by storm. The GBP heatmap shows just how profound the morale improving beating in the pound looks like. This is not at all surprising, as the pound has just realized it needs to hit parity with the euro asap if Cameron's deficit reduction plan is to be even remotely viable... and the dollar as soon thereafter as possible. Of course, if the market was even remotely normal and fund flows still mattered, futures right now would be a good percent down following the massive carry trade unwind. Instead, as there is no more real money determining equities, look for futures to explode to the upside, as bonds, gold, oil and stocks are all bought in the latest example of what bubble "diversification" for the Bernanke generation truly is.

The latest COT report by the CFTC is out: no surprises - the JPY shorts came in at near record levels after four weeks of increasing net spec short exposure. If you need to know what the funding mechanism has been for everyone who does not have access to the Fed's discount window to buy stocks at negative carry, here you go. Everyone and their grandmother is now shorting yen and using the proceeds to buy, buy, buy all risky assets. And not just yen: all the major currency pairs had net a spec short balance the week ended April 20: EUR non-commercial shorts jumped by 15,960 to -71,424, also close to record levels, while the GBP and CHF were also being shorted as the stock buying rampage was in full nitrous mode. From a massive dollar carry trade late last year, we have no moved to an even massiver non-dollar carry trade as every non-developing central bank is rushing to keep ZIRP in perpetuity.

As if the steep curve (aka free money) curve trade was not enough, today the global FX carry trade is on in full force. The yen is plunging against everything, the dollar is plunging against the euro, and commodity currencies are skyrocketing. It is the summer of 2007 all over again. The Yen is today's whipping boy, weaker against every currency in the world.

Do these observations imply upcoming curve flattening?

If you were wondering what is driving all the action in the stock market again, and, as long discussed on Zero Hedge, over the past 6 months, wonder no more. Presenting today's intraday JPY-EUR pair, better known as the carry, and best known as the S&P 500. With no fundamentals driving the market to speak of, or at least all fundamentals rolling over into double dip territory, the only safe correlation is once again the carry trade.

Following the NFP report, the AUDJPY surges by 1.42 to 81.54, after almost breaking 80 yesterday. The carry trade is back with a vengeance. The status quo is happy to continue as nobody has read Seth Klarman's lessons.

Last week in the FT the deputy governor of the PBOC was quoted as saying that his biggest fear for markets in 2010 was the risks to the $ carry trade, which China estimated was worth $1.5 trillion, dwarfing the yen carry trade at its height. Indeed, he's right to be worried, especially, as I believe, the lynchpin of the carry trade is now the Fed's balance sheet, which they are actively discussing shrinking.

Attempts by carry traders to redeem some P&L after a month of agony crashed and burned promptly, accelerating into the close as the Yen funding unwind killed not just the carry pairs but broader equities. Of particular note is the hurt experienced by AUD longs funded with either USD or JPY. It is officially time for Goldman to enter the stop losses on its various carry trades. The pain for the (leveraged) BZLJPY trade has now become unbearable.

Ready for a breakup of the Euro, anyone? How long can a sober, conservative German grandfather be expected to indulge the disgraceful habits of its party animal, thrill seeking, drug addicted grandchildren? They’re actually worried about inflation down under. If you want to know how the big boys are coining it, come this way. The trade that George Soros and Paul Tudor Jones glory in.

Revolutions happen when broken parts of existing structures reassemble themselves in novel ways. Today’s Japanese carry trade will become something completely new: currency jettison. This coming Yen carry trade is going to fundamentally change Japan. Next time, Miho Maejima won’t be hungry for yield. She has no yen for it: the carry trade will be driven by exchange rate volatility hedging. She’ll handcuff the government to the bedpost and go for full-on dollarization. When she does, shorting yen is the best trick on the planet. Dollarization to control currency volatility happens a lot. It is not even a radically new event in Japan, but it will go viral and mutate into a radically new species of carry trade. The utter abandonment of the yen to de-risk will end any return crash. And the Japanese semi-democracy (that designation applies to all nations, not just Japan) must allow it to happen. Aging pensioners are both creditors and voters: the only possible adjustment they can make to the coming sovereign crisis is by getting entirely out of yen.

As we highlighted previously, any investors who had gone long the Brazilian Real (BRL) in January, funding this position with either USD or JPY shorts, had their face ripped off after a loss of anywhere between 7 and 9% in one month (don't annualize that). But instead of covering, here is Goldman with advice on why Einstein's definition of idiocy is for chums. The firm has just come out with a trading call (remember all that huddle stuff?) telling investors to go short $/BRL "on better macro data and hawkish BACEN February 1, 2010." Who knows, maybe mean reversion will work this month. Goldman's target: 1.75 and a stop above 1.94.