The Problem with Carry: The Rise of Carry

Announcer  00:04

Welcome to the Treasury Update Podcast presented by Strategic Treasurer, your source for interesting treasury news, analysis, and insights in your car, at the gym, or wherever you decide to tune it.

 

Craig Jeffery  00:18

Welcome to the Treasury Update Podcast. This is Craig Jeffery, your host today.  We’re gonna be discussing carry as well as some other components. I’m here with a return guest, Kevin Coldiron. He’s the author of The Rise of Carry. Today’s session is called The Problem With Carry:  The Rise of Carry. Both of those are combined together. Welcome back to the podcast, Kevin.

 

Kevin Coldiron  00:42

Thanks, Craig. It’s a real, real pleasure to be back.

 

Craig Jeffery  00:46

We we spoke probably about two and a half years ago. And when we were talking, I said Are you just going to come on and say I told you so. About carry but but the not everybody can remember back probably two and a half years ago to the episode we had at that time. But maybe you just give us a quick overview of your book, just that the key theme, and then maybe get into history of some of the issues. We’ll talk about deflationary and inflationary, the carry regime, but maybe just start with a quick 30 second overview of your, your really good book.

 

Kevin Coldiron  01:23

Sure, yeah. The book is called The Rise of Carry. And it’s about how carry trades have grown from a niche strategy, say 40 years ago to one that we see everywhere in the financial markets now. So the rise of carry is the growth of this particular type of financial trade, and it’s important because carry trades, they have multiple characteristics, but probably the most important one is that their quote unquote, short volatility.  They make money if the world stays the same, and they can lose money very fast when volatility erupts. So what we see what we’ve seen in the last 40 years is when there’s episodes of rising volatility, carry trades lose money very quickly. And central banks feel an obligation to to intervene, when they intervene, they truncate losses for carry traders, which encourages them to come back and bigger size, bigger scale more, more markets the next time, each subsequent event of rising volatility, brings bigger losses requires bigger intervention. And it’s a kind of a ratchet process that that’s taken place over what we call the carry regime. And that’s kind of led us to the to the point where I now.

 

Craig Jeffery  02:42

Maybe we could talk about the carry regime, what does what does that mean? You said it, you described it as in each subsequent event gets gets bigger to handle the, you know, ongoing, let’s just say volatility. Where where are we seeing that? I know you’ve you’ve talked about the the central bank’s intervening, they’re usually buying things up putting them on their balance sheet, what what is this? What is this looking like? And how is this expanded beyond? What perhaps anybody would have thought 40 years ago, but seems to be following the path that you’ve been discussing.

 

Kevin Coldiron  03:17

It’s quite remarkable. Craig, do you think about what central bank balance sheets look like? When When, when you and I started in the business, they were very simple things. And if you look at the kind of key events, what we think are the key events that have happened over the last 40 years, each time, central banks have been forced to do more and more so say 1998, with the Asian financial crisis, that was a crash in carry trades, there was a whole bunch of classic carry trades that have been put on by long term capital management as well as other hedge funds. They were bets on falling volatility. When volatility erupted. They lost money very quickly. And the worry was that they were their bankruptcy was going to infect the people that had lent lent the money. And that would cause a systemic crisis. So the Fed didn’t actually directly intervene, but they got everyone together in a room and said, bailed them out. So they, they organized a private sector bailout, and then they backed that up by lowering interest rates. So that’s 1998.  2008, the size of carry trades had grown right because the 1998 intervention encouraged the growth of carry trades. In 2008, the Fed was forced to do a lot more.  First buy government bonds and buy mortgages, I think, actually the reverse and then eventually open swap lines where they were able to lend money to foreign central banks. 2020, again, carry trading had grown still bigger interventions were everything I just said plus intervention in the corporate bond market. by, you know, buying bonds directly in the secondary market and being prepared to buy them in the primary market, as well. So you have this kind of sequential ratcheting up of central bank intervention and and you get that same process. If you look at central banks in foreign countries as well, the way we think of it is you have these kind of structural deflationary forces operating an economy. I won’t go into all the specifics, but basically demographic forces and globalization forces have created deflationary pressure on the global economy over time, and occasionally, this erupts into kind of a deflationary earthquake. And the Fed steps in and provides increased credit like they did in 2008 2020. They provide a monetary offset to that. But now those deflationary forces, those structural deflationary forces are changing direction, they’re going to become structural inflationary forces, the demographic dividend is over western populations are aging, the integration of China into the world labor force which lowered costs that’s over that so you know, there isn’t going to be a dividend from globalization. What we said in the book is that the you know, the crisis is much more likely to be on the inflationary side going forward, then on the deflationary side. And that’s a problem because if you have a financial institution get into trouble in an inflationary environment, and the Fed follows its typical playbook of providing liquidity, then all of a sudden, it’s providing liquidity increasing the money supply when inflation is already high. And so you risk losing confidence in the central bank. So that’s that’s the, I guess, the concern, the worry that we put forward in the book and and, you know, a lot of that has, as you said, come to pass in the last couple of years.

 

Craig Jeffery  07:09

That’s how a professor says, I told you so. Appreciate you stepping, stepping through that.  When we were just prepping for this call, we talked a little bit about the British pension funds example. That’s fresh in anybody reads financial news, the Wall Street Journal, the Financial Times.

 

Kevin Coldiron  07:32

That example really worries me, because if you think about what I just said, what’s the concern, the concern is that the Fed is trying to fight inflation, right now. It’s raising interest rates, it’s not expanding its balance sheet. The concern is that if something happened, if something broke, that they would have to, you know, intervene, and then you get the situation where on the one hand, inflation is rising. And the other hand, the Feds expanding its balance sheet to provide liquidity to the markets. And that’s exactly what happened. In the UK in the last few weeks. British pension funds have, well, all pension funds, at least the way the accounting is done. Now, as interest rates fall, their liabilities go up. And that’s been a real problem, as I think most of your listeners will know, for all pension funds in the last 30 years, interest rates have fallen, the present value of their liabilities gone up, and their funding situation appears to be bad. So ideally, obviously, you’d have a, you’d have own assets that precisely immunized your liabilities. So when interest rates fell, present value of your liabilities go up, but your assets move, also move up, and you’re hedged. But typically, pension funds don’t own enough assets to do that trade to do that perfect immunization. So what British pension funds did is essentially enter into, you could basically swap contracts that tried to do the same thing. So when interest rates fell, the swap contracts would would make money, and that would, you know, a match the increase in the liabilities. But of course, it also works in the other direction. Interest rates go up, present value of the liabilities go down. That’s, that’s good, but that’s a very long term thing. Meanwhile, the swap contracts lose money, right? Because it’s supposed to be kind of matching the movement in liabilities. And that’s a short term thing, right? So if you got a derivative contract, that’s losing money. The person who’s written the contract is like, Okay, I need some more cash to back this on paper. From an accounting point of view. Everything’s fine because your value of your liabilities has fallen. Yeah, the value of your assets has fallen, but it’s a match. But the person who’s lent you the money doesn’t see it that way. They’re just like, I need more cash to To offset these unrealized losses on the swap, and so to generate that cash, they had to sell their most liquid asset, what’s their most liquid asset? What was considered to be British government bonds. So they’re selling British government bonds into a falling market, because interest rates had risen, government bond prices had fallen. And that creates a, you know, the classic kind of fire sale. And so you saw movements in British government bonds called guilts, that were just extraordinary, you know, just this huge spikes in yields, falls in prices in a very short period of time. So the Bank of England then had to step in and say, Okay, well, we’re gonna stop this fire sale by buying all the all the guilts you you want or need to sell. So they were basically doing exactly what I what I worry about, which is, on the one hand, British inflation is high, much higher than in the US because they’re facing more increase in energy costs than we are. So on the one hand, they’re saying, Hey, we’re worried about inflation. On the other hand, they’re buying a ton of government bonds, because there’s a crisis in the in the financial markets, and that risks, inflation getting really out of control. And that’s what I worry about. And I know this is kind of a long winded answer. So I’ll pause there. But I think there’s other follow on effects that I would be concerned about, if that happened in the in the US, we could talk about that.

 

Craig Jeffery  11:36

Yeah, it would be interesting to have a conversation about how much of that has been impacting the, the weakness of the of the pound of late. And there’s a couple things that went on proposed tax changes, as well as withdrawal of those. This activity inflation concerns about energy holding down energy prices, there’s a lot of moving parts. It’s I don’t know if I can formulate a good question to, to try to see if you can unwind that. I think it’s a little bit like the Gordian knot. There’s a lot of moving parts there. But I think I really want to hear a little bit more about the some of the Fed actions with what’s the the central bank of the US doing nowadays, are the consequences what you expect. And if you’re expecting those are those unintended consequences for other people who are following these policies.

 

Kevin Coldiron  12:28

I brought up the British pension fund example, because it illustrates the broader concern that I have of the Fed kind of being pulled in two directions. I want to just say something like that happened in Britain. That’s a problem for them. But UK government bonds aren’t a huge part of the global financial system. US government bonds, of course, are they’re the very core of the financial system. So if you had an odd situation like that, in the US, where there was a levered position in treasuries that had to get unwound, and you had a huge short term spike in yield, that creates some really big issues. Number one, exactly what I just said the Fed would have to step in and restart QE at a time of rising inflation. So you risk inflationary expectations, becoming unanchored. You have a whole lot of money being run in risk parity strategies, basically levered treasuries, because US Treasuries are considered to be low risk, now that that would then have to be reevaluated. And those levered Treasury positions would have to be unwound longer term banks, you know, treasuries have a very low risk weighting, because they’re considered to be the ultimate riskless asset. But if you had a huge short term move and volatility that that’s in the data that’s in the models, those risk weightings would have to be reevaluated so potentially you get less credit growth into traditional banks because of that. And in the shadow banking system. Treasuries are used as collateral for loans. And they’re really good collateral because they don’t require much in the way of haircuts. So they can be you can if you own a treasury, you can get a loan against it. Post treasuries as collateral, the person who has US Treasuries can then get a loan with those, they can re lend those treasuries again, because they’re good collateral. So an event like what happened in Britain would cause the haircuts on treasuries to increase potentially meaning less credit in both the shadow banking market and the traditional banking market. So those are the things that I that the kind of second order effect knock on effects that worry me, which is why I brought up the British pension fund example in the first place. In terms of what the Fed is doing now. Obviously, they’re there tightening monetary policy, reducing credit growth. And my fear is that something is going to break because they seem to be, they’re haunted by the ghosts of Paul Volcker. And they’re, they don’t want to be the, you know, the central bankers that let inflation get out of control. But debt to GDP now is about 350%. It was 150% when Volker was in office in the late 1970s. So I, I’m not a trained macro economist. I’m a former hedge fund manager. And I think about these things a lot. I guess the Fed has smarter people working for them than me. But it seems to me that if they wait for inflation, they keep raising interest rates until inflation falls, something’s gonna break. And then something breaks, we have these knock on effects that I talked about. So my preference would be for them to pause, and let the economy digests these higher interest rates, because I think the economy is much less able to operate with higher interest rates now, because of much higher debt levels than it was when Volcker was in office. You you unpacked quite a bit there. Let me go back to a couple numbers. You mentioned the debt to GDP about three and a half times. So our economy, the US economy is about 25 trillion right now, somewhere in that neighborhood. So three and a half times would be 87 trillion. So this is made up of what the entire debt, including debt owned by agencies, other agencies? Total debt to GDP. So that’s both public and private sector debt. Total credit. Okay.

 

Craig Jeffery  16:36

The government debt is, is what is that about? 30? It’s 30. Something trillion now, isn’t it? 30? Is it 3 trillion?

 

Kevin Coldiron  16:47

No, you’re right, that roughly GDP is about 25 trillion, as you said, so government debt is around 30. Yeah, that’s correct.

 

Craig Jeffery  16:57

It’s somewhere there. Okay.

 

Kevin Coldiron  16:58

I mean, rather, give or take a trillion here there.

 

Craig Jeffery  17:01

Well, I mean, just over the last six months, there’s been some movements there that are in the order of, you know, a trillion here, half a trillion there. And pretty soon, you’re talking about real money. It wasn’t that long ago, when there was the discussion of country’s debt, you know, the country, country level debt shouldn’t go above GDP, because bad things can happen. And at that point, I think Japan was just over 100%. But there was all these caveats there and Italy, and everybody else was reaching that. Well, now we blown past it. I’m saying this for purposes of argument. I don’t I don’t think this But doesn’t that go against some of the issues that are some of the points that can we can make a counterpoint that the central banks can pump up whatever they want? The carry level doesn’t doesn’t matter? Because we blown past certain levels that exist, and and until recently, like, we haven’t seen it, and that now inflation is breaking out? I don’t know if this is will tamp that down or if that’s going to accelerate?

 

Kevin Coldiron  18:04

Yeah, no, I mean, it’s a fair point. And I think what you’re saying is, hey, look, debt levels to GDP in Japan have exceeded 100%, more than more than 100%, 200%. Same thing in Italy. And we haven’t seen, you know, inflation, haven’t seen inflation in Japan. And the central banks just been able to, you know, absorb it basically, buy the debt. So monetize the debt, and there hasn’t been inflation. And plenty of people have pointed that out. And I guess, you know, we just don’t know, we don’t know where that that level is. But all that has taken place. You know, over the last 40 years, when we’ve had these structural deflationary pressures in place, that world is not is no longer with us. So what might have been possible in the last 40 years might not be possible in the in the next or it might? I mean, honestly, I think, you know, the financial system has changed and evolved continually over time and no one’s quite sure. I’m just pointing out where the, you know, I think the balance of risks or the balance of risks now are definitely on the inflationary side. And it goes, I’m just gonna circle back to my my previous point, which is that, you know, we rely on the Fed as a kind of market maker of last resort. Now, when when something goes wrong in a market, the Fed steps in and is the buyer of last resort. We saw that in the corporate bond market in 2020. We’ve seen that in the agency market we’ve seen in that treasury market. Could we see it in the equity market? I do. I think that’s entirely possible too.  When they do that, in a deflationary environment. That’s that’s one thing because you’re providing liquidity when liquidity is contracting. If you do that in an inflationary environment. That’s an that’s another thing. And you risk markets saying, hey, yeah, it’s great that you’re stepping in and supporting us in the short term. But in the long term, that means much more much higher inflation. So I don’t know. I mean, I take your point, and I don’t pretend to know where the the debt to the right debt to GDP level is. I just think that we’re now in a much. We’re in a situation where the balance of risks are toward inflation.

 

Craig Jeffery  20:32

Right. We know there’s some limit, we don’t know exactly where it is, we have less room to maneuver. Certainly. Or it seems certain that that’s part of the case.

 

Kevin Coldiron  20:42

I think that’s right. Yeah.

 

Craig Jeffery  20:44

Fed’s raising interest rates, we have another 75 basis point expectation, the very beginning of November, inflation expectations are there. We think it was the IMF who sent a letter to the Fed, I think asking, I can’t remember what it was asking them to consider or not raise rates as much as they are. I can’t remember exactly what that said. That seemed a bit maybe not unprecedented. But I don’t know. I don’t know if you had any thoughts on, on the overall situation, not just the IMF asking about that.

 

Kevin Coldiron  21:20

it is interesting. I said, I don’t know if it’s unprecedented or not. But I have to think it’s highly unusual. There’s been, I don’t know, the IMF so much, certainly at the BIS that the nature of the research and the way they see the world has changed a lot in the last 10 years. And it’s really become much more in line with how we see the world and rise of carry, I know that some of the senior economists there, you know, I’ve read our work and I think are sympathetic to what we’re saying. So in other words, they’re much more concerned about financial stability. And the, if you will, the feedback loop from fragilities in banking, in shadow banking, into the real economy. And I don’t think the Fed is as I mean, I think they were kind of intellectually they’re aware of it, but I don’t think it influences their policy. So I think what you’re seeing there with the IMF is those sorts of concerns, like, pretty much what I just outlined, if you keep raising interest rates, you’re gonna break something in the financial markets, and then that’s going to that’s going to have real important knock on effects. I don’t get any sense the Feds going to listen to them. They seem to be, you know, said hell bent on keeping interest raising interest rates until actual inflation declines. But I mean, we’ve got more, I don’t know where mortgage rates are now, Craig, but are they back to levels like 2005? or So units are over 7%, I think?

 

Craig Jeffery  22:55

They’re close to seven. I think just just below seven? I don’t remember if it’s the 30 year, the 15 year, but yeah, they’ve definitely changed dramatically in one year.

 

Kevin Coldiron  23:06

Yeah, that’s, I mean, we just don’t know how the economy is gonna respond to that. We do know that the housing market is basically seizing up right now. And I don’t think you’re gonna see the same sort of for selling that you did in 2008. Because we don’t have because, you know, the Adjustable Rate Mortgages are gone now. So that particular carry trade is not going to break. But ultimately, a lot of economic activity is levered to the housing market, whether it’s, you know, just housings, selling, or people refinancing, and, you know, then, you know, retailing, at, you know, putting additions on refurbishing their houses, those sort of things. So the knock on effects, they’re all going to, are all going to come off. So it just, we just don’t know how the economy is going to respond. With such a dramatic increase in the kind of key asset market in such a short space of time, it seems prudent to kind of let that sit for a little bit. I don’t get the sense they’re going to do that.

 

Craig Jeffery  24:09

And you mentioned shadow banking a couple of times maybe we can talk about that for a moment. What is what is shadow banking, there’s there’s sort of almost pejorative with the term shadow but what what is that? You know, from corporate treasurer perspective, how should we be thinking about that?

 

Kevin Coldiron  24:27

There’s different aspects of shadow banking, but it’s just credit creation outside traditional banks that traditional banks make loans. And when they make loans, they create deposits and deposits are what we use as money. So, traditional banks create money by making loans essentially, shadow banks basically use securities as collateral for loans. So kind of the what I just talked about, you know, if you if you own a treasury, you can use that as collateral for a loan, and then the person who gets that treasury can then on lend that and get the cash and the the money is typically used to buy financial assets. So it’s a way of basically creating liquidity in, in financial markets. From a corporate treasury point of view. The key aspect, I think, is, and we talked about this, in the book is The Rise of Carry when volatility is low, and interest rates are low, people look for money substitutes, they look for things to hold that feel like they’re as good as cash, but have a higher interest rate. And corporate bonds, packaged into money market funds, or ETFs, are the kind of classic money substitutes. So that’s a shadow banking operation, where you take something a bond issued by a corporation, package it into a fund that someone holds, you know, as a substitute for money. And what’s happened in the last, you know, kind of 10 years is that money market funds, because of changes in regulations now, really don’t hold corporate bonds. That’s all in ETFs. And the ETF ecosystem is, in some sense, quite different than the money market fund ecosystem used to be.  Money market funds were clearly labeled as money. So if you buy a prime money market fund, you’re, you’re buying something that is kind of labeled as like money, whereas the corporate bond ETF, you can go all the way from one that has a duration of three months out to one that has a duration of five years with higher credit risk. So my point is, in a stable environment, people can kind of move up the risk chain, they could say, oh, you know, my, my, you know, medium duration, corporate bond ETF is my liquidity pool. That’s my money. That’s my money substitute. And the longer you have a low inflation, low volatility environment, the more riskier people’s money substitutes, become. And then you when you have a and that’s, in some sense, good for corporations, because it creates demand for their for their debt and makes it easier for them to issue and rollover debt. But it also creates fragility, like in 2020, when people all of a sudden say, shoot, I no longer want any of these ETFs. And I just want to hold treasuries, there’s a flood out of those things, and the moneyness of corporate debt disappears, corporate bonds can no longer be repackaged into money substitutes. And then down the road, it makes it difficult for corporations to issue bonds to rollover debt, which is precisely why the Fed intervened in 2020. And I think that was the the the key intervention.  Even though in the end, they didn’t have to do much in terms of buying bonds, just the fact that they stood ready to buy bonds, allowed companies to issue a record amount of debt to get that refinancing out of the way. Had they not done that. There have been huge problems for companies, for treasurers. So that’s a key aspect of the shadow banking market is as these money substitutes, and it’s not like regular money, regular money is insured by the Fed and is not because of the insurance isn’t subject to runs, there’s no insurance and obviously in corporate bond ETFs. So the Fed has to provide de facto insurance via willingness to intervene and in a crisis become becoming the market maker of last resort.

 

Craig Jeffery  28:55

At no cost to those who issued the debt.

 

Kevin Coldiron  28:59

No, exactly. So they’re providing this insurance for free. And you know, what happens when anything, anything of value gets provided for free. People use a lot more of it than they should.

 

Craig Jeffery  29:11

I thought you weren’t an economist, right. The your the best line and all that was the moneyness of corporate debt disappears. I think that makes tremendous sense. As you describe that, you know, as we look, as we talk about the rise and perhaps the decline of carry or the problem with carry, is there a bigger issue in Japan, the ECB, the Bank of England, are they in a worse spot? I mean, I know we’re connected in lots of ways we being the different economies of the world. Are they in a rougher spot? Certainly if there’s significant problems with the fed with the US dollar that will reverberate across the globe because of its status as a reserve currency.  What are you thinking about some of the other central banks?

 

Kevin Coldiron  30:06

They’re struggling to fight inflation now, because interest rates in the US have for a long time been, you know, zero, and now they’re not zero. And they’re significantly higher than they were, that they are in Japan. All of a sudden, these carry trades that I’ve talked about, which for the last 10 years had been dollar funded, you borrow in dollars at zero and invest somewhere else at three, four or 5%, whatever. Now, those trades are being funded by borrowing in Japan at 0%. Because Japan’s decided to keep its interest rates low. And that pushes the currency down. Because when you borrow in yen, you’re selling yen, and you’re using those yen to buy something else. So you’ve got a currency falling to, I don’t know, 25 year lows, at the same time that commodity prices are going up. So it makes it very difficult to fight inflation. Actually, Japan, they might not care about that, because they’ve been trying to generate inflation for a long time, although I don’t think they’ve been trying to generate commodity inflation, they’ve probably been trying to generate wage inflation. But yeah, for just generally speaking, higher dollar interest rates. And this, this flood into the dollar, because it’s the global reserve currency makes it much more difficult for other countries to fight inflation because their currencies fall. I mean, the pound at one stage didn’t quite get to parity against the dollar, but.

 

Craig Jeffery  31:34

Like one O five, dollar five, or something.

 

Kevin Coldiron  31:36

But got close, which is quite extraordinary. Really, when you think about in 2006, it was $2 to one pound. So that’s kind of a 50%, fall in 15 years, and even more recently is $1.30, $1.40. So that’s a major currency falling by 40% in a couple of years. So that’s a that’s a big move. Big inflationary move. I mean, it’s funny I we talked about at the beginning, I’m actually based in New Zealand here for a couple of months. And, you know, the dollar US dollar against New Zealand Dollar is very strong, which is great for me, you know, everything seems incredibly cheap. But two New Zealanders are complaining about inflation, because for them prices are going up, but the dollar has moved by more than that. So to me, it’s, it’s good. And everyone here is frustrated.

 

Craig Jeffery  32:31

Yeah. So Kevin, thanks for that dialogue in your comments there. As we look ahead, you know, any final thoughts for the audience, which is primarily, you know, corporate treasury, bankers across the globe, no way that people from over 150 countries who listen, any other final thoughts?

 

Kevin Coldiron  32:53

I guess, I was worried that it come off too pessimistic when I do these podcasts. But I do feel like to me, this feels a lot like 2007. I mean, 2007, the Fed wasn’t raising interest rates, but it had been raising interest rates over the previous couple of years. The interest rates were 5%, there were things starting to break in the financial markets, the Bear Stearns hedge funds, then the French money market funds. You know, it really took that liquidity crisis in European money market funds before the Fed started to change tack and lower interest rates. So it feels to me similar in the sense that the Fed is kind of obstinately pursuing tight monetary policy, because it’s worried about commodity price inflation. And I do think there’s a risk of a liquidity crisis. And we talked about what happens in the liquidity crisis, that corporate debt loses its moneyness. And as if I’m a corporate treasurer, I’m thinking about having more liquidity in the short term, because I think there’s there is a worry that you could have something, you know, kind of break over the next year. I think that’s a significant risk. There is some optimism long term. I mean, you and I talked in the prep about the CHIPS and Science Act that was passed, which is a which is a $280 billion investment in basic research and semiconductor production capabilities. I think that’s exactly the sort of government spending that we need. We need more government spending on investment, and less on consumption, and it was a bipartisan effort. And that’s a step in the right direction. Hopefully, that can be a template for things going forward. So to the extent you anyone has let your listeners have influence with their representatives, you know, tell them well done on that and we need more of it.

 

Announcer  34:47

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