The Balcony Box

It looks like the Japanese have discovered the joys of frugality: http://www.nytimes.com/2009/09/21/business/global/21yen.html?_r=1

“Even through the economic stagnation of Japan’s so-called lost decade, which began in the early 1990s, Japanese consumers sustained that reputation. But this recession has done something that earlier declines could not: turned the Japanese into Wal-Mart shoppers.”

Ambrose Evans-Pritchard writes in the Telegraph: “US credit shrinks at Great Depression rate prompting fears of double-dip recession“. From the article:

Professor Tim Congdon from International Monetary Research said US bank loans have fallen at an annual pace of almost 14pc in the three months to August (from $7,147bn to $6,886bn).

“There has been nothing like this in the USA since the 1930s,” he said. “The rapid destruction of money balances is madness.”

The M3 “broad” money supply, watched as an early warning signal for the economy a year or so later, has been falling at a 5pc annual rate.

Similar concerns have been raised by David Rosenberg, chief strategist at Gluskin Sheff, who said that over the four weeks up to August 24, bank credit shrank at an “epic” 9pc annual pace, the M2 money supply shrank at 12.2pc and M1 shrank at 6.5pc.

“For the first time in the post-WW2 [Second World War] era, we have deflation in credit, wages and rents and, from our lens, this is a toxic brew,” he said.

This can’t be inflationary.

At the same time, one wonders how the dollar carry trade fits into the picture.  Does the money created by the dollar carry trade (or other carry trades, for that matter) show up as bank credit or money?  If not, could financial speculators drive asset price inflation, even while the real economy is starved for money and credit?

So now I’m intrigued by carry trades.  Since I’m not a finance specialist, I decided to start by trying to understand the mechanics of carry trades.  Jayanth Varma, professor at the Indian Institute of Management, has a concise explanation of the yen carry trade here.  I found this a bit difficult to follow, so I constructed the following a sequence of diagrams showing how they work.  Varma was kind enough to alert me to some errors in the original diagrams, and I have attempted to revise them accordingly.  Of course, any remaining errors are mine.  Please let me know if you find any mistakes.

Step 1:  Sell yen, buy dollars.  Now the fund is short yen and long dollars.

Step 1

Step 2:  Swap future yen for future dollars.  The swap is a two stage transaction in which the fund (a) receives current yen in exchange for current dollars, canceling out step 1, and (b) receives future dollars in exchange for future yen.  Essentially, the swap borrows yen and lends dollars.  The terms of the swap incorporate the interest rate that the fund must pay to borrow yen for the period of the swap (r_¥ in the diagram) and the interest rate that the fund receives for lending dollars (r_$ in the diagram).  Presumably r_¥ is less than r_$, since that is the motivation for the carry trade.

Step 2

Step 3:  Invest in mid or long-term U.S. treasuries.  Now the fund is short future yen, long future dollars, short present dollars (since it just bought treasuries), and long U.S. treasuries.  The treasuries pay an interest r_T

Step 3

Step 4:  Use the repurchase market to borrow dollars against the U.S. treasuries, canceling out the fund’s short dollar position.  This borrowing occurs at the prevailing interest rate in the repurchase market (the “repo rate”, r_R in the diagram).

Step 4

Now, with the trade in place, the fund profits from the carry. As far as I understand it, the carry is approximately the difference between the interest that the fund receives on its lending (dollars to its swap contract counterparty and dollars to the U.S. Treasury), which totals (r_$ + r_T) and the interest rate that it pays to borrow (r_¥ + r_R).  If interest rate spreads are substantial and the fund is highly leveraged, this could be a lot of money. There are a lot of moving parts here, so if I’ve got anything wrong, please let me know.

So where does the risk come from?

First, as I understand it, this is a highly leveraged transaction: the fund as taken on lot of risk without committing any capital.  Presumably there are some capital requirements for currency swaps.  If anyone understands the factors that limit leverage in these transactions, please let me know.

Second, the fund can get in a lot of trouble if the carry trade currency (the yen, in the above example) or the risky assets (U.S. Treasury securities in the example) depreciate, since the fund will then be left with decreased assets (the treasury holdings) and increased liabilities (the commitment to deliver dollars, which are now more costly relative to the yen).  What makes this particularly risky is that interest rate movements could cause both to happen at once: if interest rates rise in the target currency market, the value of the currency will tend to rise and the value of  risky assets will fall.  Referring back to the above example, consider what happens if the U.S. raises interest rates to reign in speculation: the dollar appreciates, and the value of long-term treasury securities declines.

To make matters worse, carry trades are not regulated, so we don’t know how much risk is out there.  Varma highlights the difficulties in measuring carry trades:

since derivative markets are off balance sheet transactions, we would not see the carry trade at all until we break the transactions up into their pieces and start looking at the right places for evidence of the trades.

It turns out that Peter Boone and Simon Johnson discussed the risk of a bubble-blowing dollar carry trade back in June.  From their article “The Bubble Next Time” in the New York Times Economix Blog:

The next global bubble is already under way. What happens when the most powerful nation in the world, with a reserve currency everyone trusts and holds, decides to push a big credit expansion — again, at the instigation of our financial sector? The creditworthy borrowers this time are not in the United States — they are in Asia, Latin America, and even Africa. They have little debt and great prospects; for a mere 1 percent per year they can borrow American dollars, spend the funds at home, and turn paper money into real assets. Every great bubble begins with a truly convincing shift in fundamentals.

… The coming American carry trade … weakens the dollar, lifts the economy out of recession through exports, and creates inflation that reduces the real value of our debts. This can last quite a while — both the Treasury and the Fed are sure that early attempts to tighten policy prevented serious recoveries in Japan in the mid-1990s and in the United States toward the end of the 1930s.

… are we laying the foundation for a truly massive international debt crisis?

All the more reason to keep an eye on this.

It’s probably too early to tell how significant this is, but observers are calling attention to a growing dollar carry trade.  Since dollar interest rates are being held extremely low by the Fed, and massive fiscal deficits are fueling expectations that the dollar will continue to decline, investors are funding speculative positions with cheap dollar debt.  Liam Halligan writes in the Telegraph that “Cheap dollars are sowing the seeds of the next world crisis“.  From the article:

The dollar is now being used as a “carry” currency. Traders are using low Fed rates to take out cheap dollar loans, then converting the money into currencies generating higher yields.

“Carrying” credit in this way is currently the source of huge gains. No one knows the true scale, but the world has, of course, been flooded with cheap dollars.

This presents serious systemic danger. A dollar weighed down by Chinese divestment, then suppressed further by carry-trading, could easily spring back. Those who had borrowed in dollars would owe more, while their dollar-funded investments would be worth less. This “unwinding” could send financial shock around the globe.

Speculators with positions funded by the dollar carry trade could be dealt a one-two punch if U.S. interest rates rise and drive up the value of the dollar.  Depending on the scale of the positions, this could confront the Fed with an extremely awkward decision: either leave interest rates low, leading to inflation, further devaluation of the dollar, and ever larger asset bubbles; or raise interest rates, thereby choking off the dollar carry trade, potentially causing asset fire-sales, corporate bankruptcies, or even currency crises.

To determine the seriousness of the problem would require reliable data on the dollar carry trade.  Unfortunately, given the state of our regulatory infrastructure, it seems unlikely that we’ll know much about the dollar carry trade until it shows up in macro-economic measures, at which point it will probably be to late to do anything except short baskets of non-dollar currencies and brace for impact.

It’s a trend worth watching.

One of my current pet peeves (it’s more like a personal hell) is the widespread belief in the investment management industry that the good times are back.  This, of course, is easily explained: what were once relatively worthless paper assets are now valuable.  That is, a dawning realization of insolvency and poverty has been swept aside, replaced with the prior dreams of milk and honey.  This impacts virtually all money managers, bankers, etc.

Unfortunately, the other side of the equation–households–have seen no relief of the sort.  (Indeed, the process of bankruptcy has been just made more difficult.)  This, of course, is hidden from most investment professionals’ “bubble” view, as they spend most of their time with their moneyed brethren.  It is no wonder that they feel that the good times are back.

In my opinion, there will be no return to the old “normal” until household debt has been significantly curtailed (and recall that debt/income roughly doubled in the past decade).  Currently, we are left with the worst possible scenario thanks to the extend-and-pretend bailouts: financial assets that are discounting an impossible stream of cash flows.  This will grind the household sector for many, many years to come.

Life is back to normal on Wall Street, and the prospects for meaningful reform are dim.  And the financial innovators are already gearing up for the next round of excitement.  The New York Times reports on securitizing life insurance policies, and Reuters reports that Markit has launched indices for the up-and-coming sovereign debt CDS market, so speculators can bet on whole countries going under.  Skeptics may point out that trading life insurance policies is an unproductive zero-sum game, and rampant CDS speculation helped bring the world economy to its knees.  But why let such quibbles get in the way of profits?

msnbc has posted an article about senior executive compensation at the bailed out banks titled “Options windfall likely for bailed-out bankers“.  From the article:

The top five executives at 10 financial institutions that took some of the biggest taxpayer bailouts have seen a combined increase in the value of their stock options of nearly $90 million, the report by the Washington-based Institute for Policy Studies said.

So the bailed out banks took advantage of the crash to award big option packages to their executives, probably justified by the argument that the options would give the executives incentives to restore the companies to health.  When the government saved the day with generously helpings of taxpayer dollars, stock prices recovered nicely–and the executives got rich(er).  Moral hazard, anyone?  Needless to say, if the government had wiped out the shareholders and linked executive compensation to more meaningful metrics, this wouldn’t be happening.