[Deep Dive] The Carry in the Conundrum

Preamble

This is the first of what I hope will be a long-term monthly publication of my thoughts on investing in markets. My hope is that I can show you how institutional investors look at markets and how they invest. I have had a front-seat view as an institutional investor for the past 20 years -- managing billion-dollar portfolios for some of the largest institutional investors in the world.

During the past 20 years I have had access to the best investment advice and market analysis available. I plan on sharing: the knowledge that I have gained, how to find this information, how to use it to implement your own investment strategy, how to construct portfolios and, most importantly, how to manage the risk.

During the early 2000s, I co-managed a $1 billion-dollar hedge fund with a FX and Interest Rate Carry strategy -- this was an arbitrage strategy between global foreign exchange and interest rate markets. I will go over this strategy in more detail when trading opportunities arise over the coming months. Carry strategies such as this work well in volatile interest rate markets.

I have also managed stand-alone discretionary macro portfolios for the past 20 years, including for one of the top names in the investment industry. I have had a very successful history of investing in all kinds of markets, in all asset classes. In this article and future pieces, I will dive into how to use top-down macro analysis with bottom-up fundamental analysis to come up with portfolio construction. Below is the process I have developed over the past 20 years -- always adjusting and changing according to market conditions and opportunities. As you will see from further reading, I will show how to build the themes to trade from and the asset classes and individual instruments to use to invest in them.

I learned early on that all the great traders use some form of technical analysis as a supplement to their fundamental thinking. Each one has their own favorites, but they move around, always finding the ones that are working in the current market environment. I will share things that have worked, how I use them, where to go to learn, and how to implement them on a trade-by-trade basis. There is no secret recipe or formula, but a toolbox to pick from, which can be used to help analyze markets and for trade entry and exit.

A great site to learn about different types of technical analysis is the Pattern Site. The author of the site, Thomas Bulkowski, covers numerous types of chart patterns and other methods of technical analysis. I will add more of these sites as time goes on. I know you will find this site very useful.

The first article I am writing will be on the unwinding of the financial carry trade, built up over the past 10-15 years via global central bank easy monetary policy.

I hope you enjoy reading and find my thoughts interesting enough to try a subscription. I look forward to your feedback and comments.

Part I: Unwinding the Greatest Carry Trade in Financial History

“Carry trade” involves borrowing at a low interest rate and investing in a higher-yielding asset. Typically, this has a term or duration before the investment is unwound.

What I will argue is that this concept has been financially engineered across multiple asset classes over the past 15-20 years. Some examples rely on extreme sophistication, while others are as simple as a second home/rental with a floating-rate mortgage.

Borrowing at an assumed rate that has now blown up will put extreme financial pressure on many investors -- big and small -- in all corners of the globe. There will be no place to hide. As I write this, we are starting the see the first stages of this unwind with the collapse of Silicon Valley Bank and the efforts by global central banks to limit deposit withdrawals. This is just the start; it will take multiple years to unwind. The financial losses (unrealized) occurring in the U.S. banking industry -- see Chart 1 -- shine the light on how potentially big this problem will or could be.

The chart below has been well publicized – it shows the significant impact caused by the sharp increase in interest rates. But what if the rise in interest rates is just the start of a long-term trend? If so, the compounding effects of being short the carry trade are just now getting started.

Chart 1:

One Easing Cycle After Another

Since the peak in interest rates in the early 1980s, global financial market valuations have been driven by lower interest-rate policies. The chart below shows this decline in interest rates, based on the U.S. 10-year treasury note. This policy stance accelerated after the 2008 financial crisis with the introduction of quantitative easing (QE) and the zero interest rate policy (ZIRP), opening up the door for the greatest borrowing binge in global history.

While Federal Reserve Chairman Paul Volcker is credited with breaking the back of inflation in the 1970s and 1980s using an aggressive monetary policy, this all switched with the so-called Greenspan Put. Fed Chairman Alan Greenspan, known as the “Maestro,” ran the Federal Reserve from1987 to 2006 and can, it could be argued, be seen as the inventor of the stock-market bubble. This is cleverly depicted in the book, ‘Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve,’ by Fleckenstein and Sheehan.

The Greenspan put has been defined as “a monetary policy response to financial crises that Alan Greenspan, former chair of the Federal Reserve, exercised beginning with the crash of 1987.”  Future Federal Reserve chairs had monetary put versions of their own. The Bernanke Put, The Yellen Put and finally the Powell Put -- where it is ending.

Essentially, this extremely loose monetary policy started a pattern of one easing cycle after another, resulting in lower interest rates and higher equity/asset valuations. Each crisis needed even lower interest rates to get the market to recover, and each crisis was followed by an even more aggressive accumulation of debt and leverage.

But how did governments manage to get away with the inflationary pressure that is typically associated with a loose monetary policy? Such side effects were not seen because of a number of factors, but one can argue cheap global labor supply and globalization were the primary factors in keeping inflation subdued.

With free money, everything becomes investable

This prolonged period of cheap money forced market participants to invest in low-yielding projects or assets. The upshot was that we have witnessed, for the past 15 years, the greatest carry trade of all time: the entire market operated on the basis of carry.

In essence global central banks locked rates at near 0%, pushing huge amounts of liquidity into the system forcing investors to go further out on the risk spectrum to find yield. This pseudo-carry trade is now coming to roost — as these risky investments turn sour with higher rates and inflation. These investments only made sense in a world full of liquidity at extremely low interest rates.

The Great Unwind

As recent as the first quarter of 2022, the Fed was still holding interest rate at near 0%, but since then they have aggressively raised interest rate to tame inflation, and central banks around the world have followed suit. Investors now are rethinking this process, and have to either unwind these investments at significant losses or in the case Silicon Valley Bank, depositors moved their money at lightning speed into a higher yielding investment.

A simple example of this ticking time bomb is someone buying a vacation rental property — with a low floating rate interest rate at the purchase. They borrowed short term (floating rate mortgage) and invested in a property that would take 20-30 years to pay off. Now that mortgage rates have gone from sub 3% to over 7% and inflation has increased other carrying costs of the property — the investment now doesn’t make sense and may be forced to liquidate/or sell. There are hundreds of these types of examples — thus, the term the “Great Unwind” is born.

Interest Rates Breakout

The first major change that has occurred is shown in Chart 2—referred to as the “Great Breakout”, is that interest rates have broken out of their down trend. Interest rates (10-yr in this case) had been in a declining pattern since the mid 1980’s. As the saying goes—the trend is your friend—and clearly this trend has now broken. You don’t have to be a market technician to see that something BIG has changed here.

Chart 2: The Great Breakout (US government bond 10-yr yield)

Inflation Breaks Out

The second major change causing the unwind of the greatest carry trade of all time is the breakout of inflation (see Chart 3).

Inflation, like interest rates, had been in a long-term downtrend since the early 1980s. We can argue about what caused this, whether it was increased money supply, supply disruptions, Russian President Vladimir Putin, weather demographics or other factors. The bottom line is that it has reached the highest level in decades, and most central banks around the world are forced to tighten monetary policy and raise interest rates as an attempt to bring inflation down. Federal Funds rates have now gone from near 0% in 2021 to near 5% in 2023 via the U.S. Federal Reserve Bank.

Chart 3: The Great Breakout (US inflation rate)

The last time we saw this volatile change in interest rates and inflation was in the 1970s. If you review charts 2 and 3, you can see the large increases in both. Many are comparing the current market with the price action from the 1970s. There are many similarities, which we will touch on later, all leading back to similar monetary policies by central banks. Chart 4 below shows both time periods, with a great overlay.

The current economic environment correlates with the slowdown that occurred in 1975-1976, with the Federal Reserve closer to pivoting on monetary policy today, and economic growth slowing dramatically. But as we will show later, the underlying fundamentals are potentially setting up a similar revival of higher inflation and interest rates in the next few years. We all know that things don’t repeat in exactly the same way; my goal will be to show things that cause divergence and adapt to the changes as we go forward.

Chart 4:

Surging Debt, Particularly in Japan

Because of easy monetary policy and lax lending standards, global debt has surged over the last 20 years, especially since the lows of 2008. Chart 5 below shows the debt-to-GDP ratio for the G7 economies, otherwise known as advanced economies. Debt has grown on a global basis, but the unwind began with the rise in interest rates. Percentage of GDP is a common measure used to compare year-over-year changes.

The red light had been flashing for years prior to 2022, but it is the increase in inflation and the breakout of interest rates that is putting an end to the carry trade of all time. Global debt has been growing because of the easy monetary policy by all central banks -- they have been encouraging investors and governments to believe that the risk is low. This is now changing!

Chart 5:

Looking at one country which has added a massive amount of debt is shown in Chart 6 relative to the US debt accumulation. Japan has been the greatest debt accumulator over the last 20 years of all major economies in the world.  According to Nikkei Asia, the central bank of Japan now owns over 50% of all Japan’s debt outstanding. So yes, they are monetizing their debt. Borrowing in Yen and investing globally has been one of the largest funding markets for the carry trade for the past 20 years.

When you look at Chart 6 — this data goes back to the late 1800’s. It shows how much debt has been added by Japan and the US. Only after WWII was there greater debt in the system. This is true on a global basis for all major economies. The great unwind of this debt bubble can be done either by inflating or by deflating. The market is currently in the inflating stage as shown in Chart 3. Market price action is always the signally tool.

One important point to make here is that compared to the last inflationary cycle that we had (1970’s), today we have a much, much higher debt level (chart 6). For this reason alone, the current situation is a lot trickier than the 1970s, as the economy is now hit with the double whammy of a rising inflation and soaring debt service burden. Society will not want a repeat of the 1930’s style depression either, that’s why I think the bureaucrats will attempt a soft inflation cycle — that lasts 10+ years. If we judge how they did the first go around (2020-2023), it will not end well. We should be prepared for anything but a soft outcome.

Chart 7 shows year-over-year inflation in Japan. The Japanese government is doing everything in its power to keep inflation subdued, but this will be a losing battle as the inflation genie has escaped from the bottle. BOJ wants to keep inflation manageable — within their target of 2% so they can keep their ultra- low interest rate policy in place. Higher rates equals BIG TROUBLE they want to avoid. Some would argue that Japan is the Godzilla in the financial marketplace, waiting to destruct everything in its path.

Chart 6:

Chart 7: Japan YoY inflation

Shorting the BOJ monetary policy has even been termed the “Widow Maker” by many traders who actively trade Japanese Bonds. For the past 15-20 years it has always been a loser’s proposition to trade against these bonds, but now that inflation is breaking out the tide is changing.