The Carry Risk Lurking in Your Portfolio ft. Kevin Coldiron

[00:00:00] Kevin

It’s possible in a world where we have an inflationary shock that the response isn’t sufficient to stabilize markets, in which case central banks, you know, maybe not completely lose control, but inflation becomes unanchored. So, you’ve got the, I guess, the fundamental inflationary push of higher debt needing to inflate that away. And then you’ve got maybe the monetary policy side of it where the scale of central bank intervention needs to be great.

It’s an inflationary shock and it doesn’t work that you’ve got kind of a de-anchoring of inflation expectations. Obviously, we haven’t had that yet, but those are possibilities, and I think they’re all consistent with a world of rising commodity prices, rising gold prices, et cetera. So, I feel like all those three things do fit together.

[00:01:04] Intro

Imagine spending an hour with the world’s greatest traders. Imagine learning from their experiences, their successes, and their failures. Imagine no more.

Welcome to Top Traders Unplugged, the place where you can learn from the best hedge fund managers in the world so you can take your manager due diligence or investment career to the next level. Before we begin today’s conversation, remember to keep two things in mind. All the discussion we’ll have about investment performance is about the past and past performance does not guarantee or even infer anything about future performance.

Also understand that there’s a significant risk of financial loss with all investment strategies and you need to request and understand the specific risks from the investment manager about their products before you make investment decisions. Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:59] Niels

Welcome and welcome back to another edition of our global macro series where today I’m joined by another host of the series named Alan Dunne and as well as a host of the Ideas Lab series and author of the book The Rise of Carry, Kevin Coldiron, who’s also a guest on today’s episode. So welcome Kevin and Alan. It’s great to be in the company of some very familiar faces for what I think will be a highly interesting and educational conversation. Kevin, let me come to you first as it’s been a while since we last spoke face to face. How were your holidays and your summer break?

[00:02:36] Kevin

I had a great summer, I spent a little time in Europe, a little bit of time in North Africa. You guys need to do something about the weather though, it’s pretty hot over there.

[00:02:46] Niels

Yes, true, it is getting warmer here. What about you Alan, hot summer in Dublin or..?

[00:02:52] Alan

It was definitely not a hot summer in Dublin but we’re not suffering with the heat of continental Europe but a nice and relaxing summer but no heat wave here.

[00:03:03] Niels

Well, it’s been a little bit hot in the markets, especially if you’ve been trading the yen or the Nikkei during August. So, we are of course today going to talk about a topic that is very dear to your heart, Kevin, which is carry and of course you co-wrote a book a few years ago, The Rise of Carry, which we recommend that everyone should read. And that’s really where I want to start off.

I want to kick off with kind of where you left after you wrote the book The Rise of Carry and kind of take the next step, the next evolution of this topic. So maybe to start off with, maybe you could summarize the key conclusions you drew back then when you finished the book, and maybe which of these conclusions we have subsequently seen mostly play out in real life examples.

[00:03:58] Kevin

Okay, thanks, Niels. Yeah, so, I mean, the main thesis of the book is that carry trades over the last 30 to 40 years, a period that we call the Carry regime, have grown from being niche strategies that mainly were applied in the currency market and commodity markets to strategies we see everywhere, everywhere across the global financial markets. And they’ve grown in size and scale to the point where financial markets, the global market really behaves as a kind of, if not a giant carry trade, they have the characteristics of a carry trade.

What are the characteristics of a carry trade? They’re always levered, in our definition. They’re always liquidity enhancing. They’re channeling money from where it’s abundant to where it’s less abundant. They’re short volatility. So, they do well when the world stays the same and they do poorly when volatility spikes when things change and they have this, you know, kind of corresponding return pattern, which is steady upward profits most of the time and then occasional very large drawdowns.

So, our conclusion from the book was that financial markets are all kind of adopting those characteristics and that what we’re going to see is a lot of carry trade like patterns in the world. And that’s turned out to be true. We published actually, just in the end of 2019. Then of course, in 2020, we had the COVID crash, which had the dynamics exactly as we described.

And then we, you know, we’ve more recently had this kind of mini episode in August where again, the global markets were, you know, clearly upended by a carry trade and had displayed the exact pattern that we discussed. So, I feel like the broad conclusions of the book have proven to be correct.

[00:06:06] Niels

Can I ask you on one thing? I think we all probably remember because it’s so recent about the yen and the unwind, to some extent, that we saw in August, but I noticed you said the COVID. How do you see what happened during the COVID sort of February/March, how do you tie that into carry? Because people might think, well, hang on, this had nothing to do with carry. There was a pandemic that suddenly rose. What were the patterns that you saw that makes you say, yeah, that’s definitely linked to the world of carry?

[00:06:43] Kevin

Well, taking a step back, carry is a trade that, you know, we say right at the beginning makes money if nothing happens. So, using the yen carry trade and as an example, you borrow a yen at zero, invest in say Mexican peso at 10%. That yield spread is 10 and if it’s levered, it’s much higher. So, in a world where nothing changes, in other words, the world where that exchange rate does not change, then you make money. So, it’s a bet on stability.

The point is that something happening could be something fundamental. There could be something fundamental in Japan. They raise interest rates. There could be something fundamental in the recipient currency, they lower interest rates, but it doesn’t have to be.

It can be a move that’s big enough, because remember these trades are always levered, and levered trades are not stable. So, it could be a “random event”. It could be an event that just causes markets to move enough where people have to compress, close their position and that causes trades to lose more money. And then you get this kind of unwind dynamic that I think a lot of listeners are familiar with.

So, the COVID crash, you might say, well, “Hey, that’s got nothing to do with carry. That was a global pandemic.” And so, in this case, the trigger was “fundamental”, right? There were fundamental reasons for markets to fall, but once they started falling, then these levered carry trades started losing money and then, you know, you get this unwind dynamic. If you look at what happened in the VIX markets in those kind of few days, I believe it’s, we’re talking end of February, early March, 2020, there was just an absolute explosion in the VIX, and the VIX rises.

In other words, short volatility trades lose money violently. And I know that there was a number of volatility traders that literally did not survive that period. So, in that case, the trigger was fundamental, but the dynamics were exactly what we would expect in a world where there’s a lot of these carry trades present.

So, the trigger can be fundamental, or it can be, you know, non-fundamental. It doesn’t matter. The carry trade is, it’s fragile. It’s exposed to that sort of thing.

[00:09:14] Niels

Yeah, that makes perfect sense.

Before we jump into kind of the topics of looking forward and furthering this discussion, I’d love to know if there’s anything that you feel, from the book that you wrote a few years ago now, where you made some conclusions that maybe turned out kind of differently. I wouldn’t use the word necessarily that they were inaccurate, but maybe had surprised you, saying, well, maybe this is actually a little bit different to the understanding we had at that time, because of course we now have five more years of data experience. Is there anything that surprised you since?

[00:09:53] Kevin

Well, one thing that’s changed has been the role of the dollar as kind of a recipient versus a funding currency. So, when we wrote the book, dollar interest rates were very low and we have this diagram, which my son says no one can understand. So, I’ve subsequently revised it for my students so that they can understand it.

But the basic point is that with US interest rates low, the dollar was a funding currency for carry trades to dollars. People would short the dollar and go long in, say, emerging markets. Also, there was a kind of, if you will, fundamental circulation of dollars where the US had a current account deficit.

Those dollars build up outside the US, mainly in China and in commodity exporting countries. And then they would invest those dollars into treasuries and that kept US interest rates low and it kind of kept this kind of flow going.

Now, I’ve written a fair amount about this, but that subsequently changed. China does not automatically recirculate its foreign exchange or its dollar reserves back in the US treasuries anymore. So that flow, certainly that direct flow is not as strong as it used to be. So that’s definitely one fundamental change. The dollar, with higher interest rates, was not serving as the kind of main funding currency, and that gave rise to the end carry trade.

I mean, it’s actually very unusual. If you look back at the full history of short-term interest rates within developing markets, it’s very unusual for the dollar to have kind of the highest, or close to the highest interest rate. It’s only happened a couple of times over the last 30 years. So that made the dynamic different. That the funding had to take place in a less liquid currency like Japan, which makes it a little more fragile, number one.

The second thing, I think, in terms of what we would have predicted versus what happened, I think we would have expected, and I’ll be completely honest with you, we did expect (like a lot of people) that the rise in interest rates would have had a more immediate and detrimental impact on the economy. Because interest rates should increase the cost of leverage. And we document that the US economy is highly levered. So, you’re thinking, well, that’s going to influence the economy negatively more than it has.

So, a lot of work we’re doing now on our second book is kind of trying to understand why that didn’t happen exactly how we would expect. I think we made some interesting progress on that. I don’t know if that’s something you want to talk about now or later.

[00:12:50] Niels

Oh, well, whatever you want to do, so to speak.

[00:12:55] Kevin

It’s a little nerdy, but I mean, the idea that if you think about what has gone on in the US economy since rates have risen, certain sectors have definitely been hit, real estate for sure. But in general, the economy has done quite well. And actually, the BIS did an interesting kind of, I guess, summary of what happened with the end carry trade unwind. And they had a graph in there that showed hedge fund leverage over time. I’ve been able to recreate that data and what it shows is that, you know, head fund leverage actually went up over the course of late 2022, ‘23, and so that’s a little surprising. You think, well, interest rates have gone up. Normally you would expect leverage to fall. So speculative leverage has actually increased.

What we’re thinking is that part of what’s going on here is that as interest rates rise, that increases the value of the Fed put. If you think of the Fed put as basically insurance that the Fed is providing to markets. If markets fall a lot. The Fed says we’re going to step in and make sure it doesn’t get out of hand.

So as interest rates rise, they’ve got more scope to do that. They’ve got more scope to step in and support markets. It’s a little counterintuitive, but as a levered trader, really, you don’t care as much about your funding costs as you do about the expected return on the asset that you’re going long.

So, if you have a levered long S&P 500 trade, sure, it’s less attractive if you have to fund that at 5% versus zero. But what we really care about is the potential upward movement and then your downside risk. And that’s driven by the potential movements in the S&P 500.

So, if the Fed put becomes stronger, then that kind of could encourage you to take more levered positions. Of course, leverage at some point has to run up against constraints, the availability of money to borrow.

And that’s where the second change comes in, which is the paying of interest on reserves. So, with huge, well now I think 3 trillion (but was even higher) of reserves with the Fed, and the Fed paying interest rate at 5%, that’s basically a direct subsidy to banks. Banks are getting interest of the order of, I think over the last two years, it’s like $500 billion.

So, I guess what we’re saying is that while on the one hand, the Fed is doing quantitative tightening to try to constrict the money supply. On the other hand, it’s paying interest to banks, which actually increases the money supply. So, you’ve got this kind of taking away with one hand and giving with the other hand.

The bottom line is that it just means that the funding constraints bind at a kind of a higher point. They’re not as tight because bank reserves are rising with the earning of interest. So, the combination of the Fed put being stronger and the constraints on leverage maybe not binding right away, allows sort of speculative leverage to continue rising, maybe more so than we would have imagined. I think that’s been a change that we’re…

I should say that a lot of those ideas are things that Tim Lee, my co-author, has worked through. He’s a very talented economist. A lot of times what I do is just, you know, take his ideas, think it through and see if I can find some data to back it up. So, it’s a fun dynamic.

Also, these are ideas that are still in the formative stage, but that’s kind of where we’re thinking right now. And that’s an idea that wasn’t in the first book and we hope to flesh it out more in more detail in the second book, and hopefully we can get published soon.

[00:17:04] Niels

Fantastic. Good stuff. Well, now we’re going to get to the real crux of the matter. So, I need to turn it over to Alan, who is much better at diving into some of these details than I am.

[00:17:15] Alan

Good stuff. Well, maybe, just to follow up, as we’re talking about some of these points like the rise in interest rate. What just strikes me as one of the areas where we did see an issue which, I guess, is a carry trade, was Silicon Valley Bank. He would have been borrowing, getting money on deposit and investing in bonds. That’s a good trade as long as nothing happens, but rates did move. So that had a big loss in the bonds, but they were bailed out or the system was bailed out.

So, I mean, it’s probably not the case that we didn’t see any blowups, but just that they were well contained. Isn’t that fair to say?

[00:17:55 Kevin

Totally, and that’s a fascinating dynamic, right? And to take a step back, what we say in the book is that the global economy up untill let’s say 2020, the shocks that hit the global economy over that, what we call the carry regime, they were deflationary shocks, 1997, 2001, 2002, 2008, 2020. Those are all deflationary shocks.

So, when you respond to a deflationary shock as a central bank, by injecting liquidity via lowering interest rates or QE, you’re working the direction of the underlying fundamental risk. The underlying fundamental risk is deflation. You’re providing more money to the system.

So, you’re saving financial markets, but you’re also fighting the underlying risk of deflation. But in a world where the underlying risk is inflation, then responding with a liquidity injection is, you know, that’s a lot riskier, right? Because the markets could be like, “Well, hold on.”

Okay, yeah, you’re trying to save Silicon Valley Bank, or the British pension fund system by injecting liquidity, but inflation’s already 4% or 5%, or whatever, and that’s, I think, the key risk that we’ll face going forward, or the key kind of determinant of whether or not the Fed sort of gets away with it or not is whether they’re trying to fight an inflationary crisis or a deflationary crisis.

Now, in this case, yeah, they were fighting a liquidity issue with banks, pension funds by injecting liquidity when inflation was high. So, there was a risk that this thing could spiral. But in the end, it didn’t.

[00:19:41] Alan

A lucky escape.

[00:19:43] Kevin

Kind of. You know, that’s how I think of it as well. They got away with it. I actually wrote a piece on that where it really it comes down to the market. What the Fed is saying is that this is a kind of liquidity issue, not a solvency issue, right? So, it’s basically back to that old question.

If the market buys that, then the temporary injection of liquidity solves the local problem, and things don’t get out of control. But if the market doesn’t buy that, then they have to do another round of intervention which increases the risk of inflation, and you get a riskier situation.

So, it really comes down to whether or not the particular problem that the central bank is fighting, whether it’s British pension funds or Silicon Valley Bank, is perceived by the market as a local liquidity problem that can be solved or it’s perceived as a symptom of a wider problem. In this case, they were both perceived by the market as a local problem that can be solved, and they were.

So, we’ll see. I don’t think that’s the end of that sort of dynamic. Actually, the bank of England did a really good piece, in the aftermath of the British pension fund episode, where they basically said the same thing. Yeah, it might be interpreted as a bit strange that we’re injecting liquidity when inflation is high. So, central banks are obviously aware of it and I’m kind of impressed at their honesty in that write-up.

[00:21:18] Niels

Can I interject one thing actually, before you continue, Alan? Regarding that episode, I seem to have recently heard a podcast episode (and I don’t know if it was an old one or a new one), where they kind of reminded me that yes, the bank of England injected a lot of liquidity, but they offloaded it again very, very quickly after the episode itself, which was kind of interesting that they managed to do that operation within a couple of weeks – getting in and getting out.

[00:21:49] Kevin

I might not know all the details, but it felt like a lot like this Feds intervention in the corporate bond market in 2020. Remember the Fed said, “Hey, we’re going to buy corporate bond ETFs. We’ll even buy new newly issued corporate bonds.” And just the fact that they said they were prepared to do that meant that, in the end, they didn’t have to do very much. They actually did buy a little, but very little. I think that, in England, it was kind of the same thing, the willingness to say, well, whatever bonds you want to sell, we’ll buy was kind of enough for the private markets to sort of get back to functioning. But I could be wrong about that.

[00: 22:30] Alan

I think that’s right. I mean, I think the worry in the markets was because, central banks were tightening policy, their hands were tied, so the bank of England couldn’t intervene in the gilt market because of the conflicts that Kevin is talking about, but it got to a point where they were able to justify it on a kind of extreme market dislocation. Then people knew, okay, so that scenario where their hands are tied doesn’t apply. So, it took away that risk.

And also, I think the problem in the UK was that the pension funds didn’t have access to liquidity to be able to meet their margin calls. And I think over time that got addressed and kind of helped solve the crisis. Yeah, I mean, there was that conflict there.

One thing I wanted to move on to is the whole area of equities and the S&P 500. I saw that the FT picked up on something that you wrote recently where it says the S&P 500 being the kind of the essence of a carry trade. Which got me thinking that, for sure, in the period of the 2010s, when interest rates were low, it was a classic strict definition of a carry trade. If you borrowed and invested in equities, the dividend yield was above the funding costs, so you’re a positive carry. But now obviously rates are higher, so it’s actually, from a kind of a futures trader’s perspective, it’s negative carry if you’re long the S&P, even though it behaves like a carry trade.

So, I’m curious to get your perspective on how you see it behaving like a carry trade, even though you might question whether it is actually a carry trade.

[00:24:14] Kevin

Yeah. Thanks Alan, that’s a good point. And I think a lot of people like you, who come from a trading background, get a little confused and probably rightly so. We probably shouldn’t call it a carry trade. Maybe it behaves in a carry like manner. I don’t know exactly a better way to phrase it, but yeah. What you’re saying is that, from a trade perspective right now, with higher interest rates, taking a levered long position in S&P 500 is kind of negative carry. Your funding costs are higher than the expected yield on the trade.

So, why are we calling it a carry trade when it’s got that dynamic? You kind of have to look and go a level or two below. At one level that we think about is what I call kind of the banking perspective. So almost like S&P 500 companies, and the index behaving like a bank in the sense that the underlying companies can, if you look at the yield on their debt relative to their earnings yield, that’s a positive spread as it should be. So, in other words, issuing debt and buying back equity is positive carry.

We’ve seen a lot of that activity. So, what you see is the companies that are doing more issuance are the ones that have a higher spread. They have higher earnings yield relative to their cost of debt. But there’s another dynamic that’s important, that we talk about in the book but, going back to Neil’s point, has accelerated a lot in the last five years, which is what happens to that debt that gets issued.

So, companies issue corporate debt. In the old days corporate debt really didn’t trade very much. It was very illiquid, but that’s changed dramatically in the last five years, last 10 years with the emergence of ETFs. So, the S&P 500 companies issue debt. Now what happens is that gets rolled into an ETF that is very liquid. Those ETFs then get held by asset managers as cash substitutes or cash like products. So, it’s a classic liquidity transformation, right?

What do banks do? They do liquidity transformation. You take debt that’s not that liquid, you package it in with something that trades a lot, and then, you or me can hold a short duration corporate bond ETF instead of a money market funder; instead of cash in the bank, because I know if I need to liquidate it, I can.

So, at a macro level, what’s happening is that the index is providing a banking like service. It’s got monetary liabilities, the debt gets packaged into ETFs, and it’s got a levered balance sheet.

Now, I don’t want to oversell it. I’m not saying the S&P 500 is a bank, but it’s playing a banking like role and banks are classic carry institutions. They borrow at low rates and invest at higher rates. So that’s one way to think about it.

Another way is what I call the insurance perspective, which is the piece that the FT picked up on, which is just basically saying that if you’ve got a risk anywhere in the world, you can hedge that risk, to some extent, in the S&P 500 ecosystem futures options, options on VIX, VIX futures. So, in that ecosystem, the liquidity is kind of unrivaled.

There’s no other risk market in the world. I’m talking about risk markets now. I’m not talking about bond markets, or equity markets. There’s no other risk market in the world that can absorb those hedging demands. So, it’s basically providing this kind of insurance service to the rest of the world. And, insurance, again, is a classic carry business, right? You’re, earning a premium and occasionally you make a big payout.

Then the third perspective is kind of what I call the tail wagging the dog perspective, which is that the volatility of the S&P 500… As a student, you say, “Well, how do you calculate volatility?” Well, you look at how much the underlying is moved over a certain horizon, the standard deviation of that, that’s the volatility. So, it’s a derivative measure. It’s driven by what happens to the underlying.

But in the world that we’re in now, people can trade, they can’t trade the VIX directly, but they can trade VIX futures, VIX options there. And those things are highly correlated with the VIX. So, you actually have the volatility having its own underlying dynamics. Shorting volatility, shorting S&P 500 volatility is the ultimate carry trade. It literally is directly selling volatility.

So, when the markets are stable, that’s very profitable. When it spikes, you can lose a lot of money very quickly. And that carry behavior of the volatility basically converts or drives the underlying behavior of the market.

So, you’ve got the tail with something that should be a derivative measure, volatility actually having its own behavior that drives the underlying. So, it’s kind of like this two-way complicated interaction. That’s not how we would have imagined the market working 20, 30, 40 years ago. So, all three of those things are a little bit deeper understanding of how the S&P 500 behaves like a carry trade.

[00:30:19] Alan

I mean, just taking that in the context of what we saw in August, I think one of the things that got highlighted in the BIS report is that the move in the VIX was disproportionate to the move in the S&P. Or the S&P didn’t fall that much given the move in the VIX. So obviously, it feels like it sometimes, that the leverage builds up in the spot market or sometimes the stresses, and the vulnerability is more in the options market. Is that just reflecting capital flows and where stresses build up over time? It’s hard to kind of anticipate an advance or get a perspective on what that means that you get those inconsistencies.

[00:31:04] Kevin

Yeah, I’m not close enough to the underlying… I’m not managing money anymore, so I’m not as close to the prime brokers as I would have been 10 years ago to really get a feeling of the microstructure. But if you just look at that move in the VIX over that couple of days, particularly that massive spike, I don’t know, it was it Monday or Tuesday, I can’t remember, where it went to like 60 briefly.

That feels like someone just getting absolutely squeezed out of a position. That feels like a short volatility or short correlation trade where literally you’ve just got to sell at any price, or someone sells for you at whatever price they can get.

So, it’s that kind of move where there’s a massive spike and then it comes back down. It feels like just a liquidation. I don’t know, Niels, I can see you shaking your head, yes. You’re familiar with these sorts of episodes in the commodities markets.

[00:32:01] Niels

Yeah, and I think you’re right in the sense that also, of course, the move we saw in Japan was pretty large, but in many of the European financial markets, it wasn’t too bad. I was just thinking also that with these zero-day options now and all of that, I think it’s definitely exacerbated some of these short-term moves. Even though we saw the biggest rise in many years on that Monday, we saw the biggest decline and in volatility the next day. I mean, it’s completely crazy, right?

[00:32:32] Kevin

You know, Jamie Lee, who’s one of our co-authors, he’s a volatility trader and he’s been talking about this. I don’t want to put words in his mouth too much, but over the last year to year and a half. Typically, when you get these big inversions, so inversions of the VIX futures curve where the VIX spikes dramatically… So typically, the VIX futures curve is upward sloping, but if you get a big spike, it can be downward sloping. Historically that’s tended to portend a period of just overall higher levels of volatility for the market.

And yeah, we do hint at this in the Rise of Carry. I’ve looked at a lot of indicators; can you use the VIX futures market to time the underlying? Only if you can trade really, really quickly in the market. The models are very precise. But in any case, that situation where a VIX inversion then leads to a state of higher volatility and poor performance for the market seems to have broken down a little bit in the last 12 to 18 months where, you know, you get the VIX inversion, but the underlying market holds up pretty well. And I think that’s pretty much what we saw in August.

And I don’t have a great explanation for that. So that’s kind of a puzzle going back to one of your earlier questions, Niel’s, about what might have changed since the first time we wrote the book. I think that seems to be something that’s changed.

These VIX inversions aren’t triggering a higher volatility state that lasts in the way that they might have done in the past. So, it feels like something structural has changed, but I haven’t quite been able to put my finger on why or what.

[00:34:25] Alan

Just one thing I wanted to kind of delve into, and it’s more of a definitional thing, but I’m curious to understand. I mean, you touch on short volatility and carry. So, an outright short vol trade and a carry trade behave similarly and obviously in a risk off period when carry trades tend to be unwound, shortfall trades tend to get unwound.

So, obviously some things are clearly short vol, some things are clearly carry. I mean, is the differentiation between the two useful, or are they both kind of part of an overall category of risky trades?

So obviously you call it The Rise of Carry as opposed to The Rise of Short Vol Trades. So, there’s obviously some kind of distinction. I’m curious to get your thoughts.

[00:35:18] Kevin

It’s not as snappy to say The Rise of Short Vol Trades. Short vol trades are clearly carry trades, right? The classic one being, you know, say shorting VIX futures and having it roll down the curve. I’m not sure many people do that in that ultra simple form, but if you short a VIX future at whatever, 20, and the VIX is at 15, just using kind of crude numbers, then if nothing changes, if the world stays the same, then your future eventually rolls down the curve and becomes the spot. So, you short at 20 and eventually you’re able to close out the position at 15. If you hold that for a month or two levered, that’s very attractive. So that’s shorting volatility. And of course, when shorting volatility, obviously you’re going to lose money when volatility goes up. So that’s a pure extreme carry trade.

Well, I guess our point is that other carry trades, structured differently, still have that common risk factor underpinning them, which is that they’re going to lose money when volatility goes up.

So, you could say that I’m doing the end carry trade, or I am selling put options on the S&P 500. You could say I’ve got private equity where I borrow at very low interest rates and invest in companies with higher underlying earning yields. You can structure those fundamentally and not think that they’re correlated, but they are going to be correlated because they all share that common risk factor of being short volatility.

What was the argument in the book is that, over time, that common risk factor really has become S&P 500 volatility. So, whereas, again, when I started in the 1980s, if you look at the correlation of currency carry to the to the S&P 500, it was pretty low, not really correlated. So, you could argue that that that short volatility risk factor was different, but they’ve merged over time. They really have.

So, I think it’s very difficult to build a “diversified basket” of carry trades now. You can structure carry trades in a lot of different markets, but they’re going to share a common risk factor which is S&P 500 vol, global vol.

[00:37:59] Alan

Did you want to jump in Niels?

[00:38:00] Niels

Yeah, I might go in a slightly different direction. We can jump back and forth. But something that just was kind of quite interesting a couple of days ago when I was recording last week’s episode with Adam Rosenzweig, which is about commodities. And then suddenly he breaks out giving you, Kevin, a huge endorsement.

He suddenly started saying that, oh, yeah, he got highly recommended this book by Neil Howe (by the way, who has been on your show, Kevin), The Rise of Carry, he says. Cem and I were kind of smiling saying, yes, well, that’s actually co-written by one of the other hosts on the podcast. And we could say that, well, you’re going to be on the show this week.

Anyways, now let me try and see if I can make… I don’t know if it’s a real question here or something. I’d love your thoughts anyways. It seems, from a carry perspective at least, that stable and low inflation, I should say, and this globalized world, was maybe where carry kind of was facilitated or made possible or made easier at least by central banks.

And maybe in the last couple of years, we’ve seen signs that this may be changing, that they cannot kind of control and rely on stability and low rates the way they did. I don’t know if it’s just the fact that we may not get as much carry in that world, because you would think it’s a little bit more risky to do carry when you don’t have that stability we had for quite a long time. So, I don’t know if this is enough of a “change in the monetary system”, because it’s really outside the system, but it has an impact on the system.

Adam was sharing that in their research, what they had found was that often you get these commodity super cycles, which he and others we know (Goldman Sachs and others), are kind of expecting that we have started. I was just thinking whether a shift in the carry world, so to speak would… Well anyway, to say what he says, he says that often they see the super cycle begin when you have a change in monetary system. I forgot to mention that.

So my question I guess is whether you think a change in the world of carry (and I think you were actually, in the book, expecting higher inflation and so on and so forth), whether a change in carry might be enough to be seen as a change in the monetary system very loosely, at least. That actually, would fit in with the timing of this commodity super cycle, which Adam and other experts in commodities are expecting.

[00:40:59] Kevin

Okay, there’s a lot in there and broadly speaking, I agree with that. I really do. We do say that, remember going back to the fundamental characteristics of carry, carry trades are levered trades. So, the rise of carry, the growth of carry, implies a growth of leverage across the financial system.

We clearly see that if you look at debt statistics, you can’t measure leverage properly because there’s a lot of off balance-sheet leverage through options, et cetera, that we can’t measure precisely. But I mean, I think it’s pretty safe to say that the financial system is much more levered than it ever has been. And so, we talk about that ultimately for the carry regime to end it’s going to require inflation; it’s going to require inflation for that debt to be inflated away.

We also say that although central banks in the world that we’ve been living in seem all powerful and they seem to be able to head off any crisis, which is what Alan and I were talking about, and they have been able to head off any crisis. The required size of each intervention gets bigger and bigger over time because carry trades get bigger and bigger. So, it’s possible in a world where we have an inflationary shock that the response isn’t sufficient to stabilize markets, in which case central banks maybe not completely lose control, but inflation becomes unanchored.

So, you’ve got, I guess, the fundamental inflationary push of higher debt needing to inflate that away. And then you’ve got maybe the monetary policy side of it where the scale of central bank intervention needs to be great. It’s an inflationary shock and it doesn’t work that you’ve got kind of a de-anchoring of inflation expectations.

Obviously, we haven’t had that yet, but those are possibilities. I think they’re all consistent with a world of rising commodity prices, rising gold prices, et cetera. So, I feel like all those three things do fit together.

What we’re trying to do in the second book is say, okay, well, what would we expect to happen to interest rates as we progress? Are there certain signs that we can look at to decide whether or not we’ve entered that inflationary regime or not? We haven’t really got a clear focus on that yet but we’re working on that. Tim’s worked on this indicator that he calls a deflation shock indicator where he’s trying to take some of the ideas from what we’ve talked about to at least suggest whether or not the next shock is likely to be deflationary or inflationary.

The idea is to look at the probability of a kind of a dash for cash; a deflationary shock by looking at cash holdings and by looking at money supply. So, basically if cash holdings are very low, financial market financial asset holdings are very high relative to GDP, that’s suggesting that people are holding a lot of wealth as cash substitutes in non-cash assets so that if there’s a shock, there’s a risk that there’s a flood back into cash.

And then if you also look at the money supply growth, if you look at the ability of the system to provide that cash and kind of combining all three of those things together, that is what he’s been trying to work on to suggest whether or not we’re, like I said, in an inflationary or deflationary world.

I’m rambling a little bit. Broadly speaking, I agree with Adam’s perspective and your characterization of it.

[00:45:11] Niels

Sure, sure. And actually, my next question was in terms of where you were on this indicator that I’ve heard you talk about or maybe I read that you were working on. Before I turn it back to Alan, I was just curious, actually.

And of course, we don’t give investment advice on this podcast. So, this is purely sort of a conceptual idea. And since you have been managing money in the past, I thought it would be fun to ask you.

How should people think about trying to make money from an unwind of carry if you don’t know “which carry trade is going to be unwound”, so to speak? I mean, it could be currencies, it could be stocks, it could be bonds. I mean, how do you do that?

[00:45:54] Kevin

I spent most of the early summer thinking about how I can make money from the end carry trade unwind. I’m not saying that I had any great foresight, but I mean, it was pretty obvious that trade had grown very, very big. Everyone was talking about it. You knew it wouldn’t take much of a trigger to lead to an unwind. But then the tricky thing is, well, how do you make money out of it? I looked at setting up a yen bank deposit account where I just moved dollars.

But, you know, then you’re paying away the carry, right? You’re moving money out of a money market fund in the US at 5%, putting it in Japan at zero. Now, that’s kind of an unlevered trade for me.

So I was kind of like, what’s the point, really? You only make money if you lever it, but then if you lever it, then you’re paying away double, triple, four times the carry. You could do directly via currency futures, but it all comes down to if you’re trying to make money directly through a carry unwind, the timing has to be very, very precise. And I just don’t think that’s something that a kind of a normal investor, even a lot of professional investors can do. So, that’s kind of the paradox, right? It’s very hard to lean against carry.

One thing you can do is, with higher interest rates in the US, you can say, well there’s option value in having cash. And I can buy these assets to get unwound at a discount if I’m sitting there with cash, and I’m sitting there with like a limit order at 10, 15, 20 (pick your level relative to the current market). So, I did a little bit of that where I just had limit orders in markets that I thought would be affected. A couple of them got triggered.

But that’s, I guess, trying to buy the dip, which we also talk about as kind of like a form of carry trade as well. I haven’t come up with any fancier or smarter ways to do it than to just look for vulnerabilities and say, OK, well, I’m willing to step in at some point below the current level and have some cash to be able to do it.

Now, like I said, that’s a little more comfortable thing to do when US interest rates are 5%, because you think, well, worst case scenario is I’m sitting in cash and I’m earning five percent, inflation is 3%. It’s a positive real return. There are very low opportunity costs for doing that. If you’re back to a zero percent world where inflation is positive, then that becomes really hard to do, really hard because there’s negative opportunity costs for sitting in cash. So, it ain’t easy.

[00:48:45] Niels

So now I know where your son got it from because I remember a story you shared on Odd Lots where you said something about that you were coming in at eleven thirty at night saying good night to your son. And he said, yeah, I’ll go to bed. I just need to put in my limit orders, right?

[00:49:00] Kevin

Yeah, he was a COVID era speculator. And he learned some lessons over that period. Let’s just let’s just put it that way.

[00:49:15] Niels

Alan, why don’t you take us into the final stretch?

[00:49:19] Alan

Yeah, well, maybe just to come back and get into just a couple of points that we touched on, and I think that we were talking about, because they link to the inflation/disinflation thing. I mean, coming back to the Fed put idea, which Kevin kind of suggested is kind of critical to the whole regime, it has become a feature of the market, and it’s ever present. For a period in 2022, it felt like the Fed put maybe got away because obviously the Fed were talking very hawkishly and raised rates aggressively. And the market went down without really having a collapse. You know, it was a very orderly decline. So maybe the result wasn’t tested.

So obviously, if we did go into an inflationary environment, you would possibly at some point have that policy conundrum for the Fed where you get something. But the point I want to talk about was, you know, with the increased financialization of the of the markets, of the economy, but the economy is now so tied into the markets, when the markets go down it influences the economy. We used to look at the economy to tell you when to buy and sell the stocks. Now, obviously, when stocks go down, there’s a big wealth effect. So, I’m just wondering, will we ever get away from the Fed put, given the increased financialization of the economy?

[00:50:44] Kevin

It seems very difficult, doesn’t it? Very, very difficult for them. You make an important point, though. They did raise interest rates aggressively in 2022. The market, I think, fell 20% or something like that in an orderly fashion, but it did fall. So that was like encouraging. And I was very interested in early August when the market fell.

There were a couple people calling for an immediate cut, which would have been executing on the Fed put, and they didn’t do that. I wonder how long they would have held off had the market continued to go down. And we’re going to get an interest rate cut coming up here soon, so you could argue that they are going to make good on the Fed put.

But, you know, they didn’t react in real time. But I think your broader point is probably more important long term that the financialization of the economy, the fact that credit now is created more through the markets than the banking system, that we’ve encouraged everyone to have defined contribution pension plans. So, everyone knows, not everyone, I’m exaggerating, but a lot of people have a kind of beta to the market that maybe they didn’t have 20 or 30 years ago. So, it becomes very difficult for the Fed to tolerate a long period of asset price declines, or sharp period of asset price declines. It just puts more pressure on them.

So, yeah, I think it’s tricky. I think the Fed puts going to be with us for a while. And then, of course, you know, if the Fed put… It’s frustrating for fundamental investors, right? Because if the Fed puts going to be with us for a while, then what’s the logical conclusion? Well, the logical inclusion is to be long risk assets, even though, maybe relative to earnings, that doesn’t seem like a very smart thing to do.

Where is the Fed put most prevalent? The S&P 500. Where has the valuation of markets relative to, say, GDP gone up the most? The S&P 500.

If you look at the valuation of, say, mid and small cap companies, over the last 30 years, relative to the economy, it hasn’t really changed very much. But the S&P 500 has gone from, I don’t know, like 40%, 50% of the economy to 140%.

So, it feels like where the put is kind of most applicable is where people are putting their money, which is in some ways rational, but also very difficult. If, like us, you were sort of trained in fundamental investing. I know a lot of people my age have just been banging their head against the wall for 10, 15 years because fundamentally it hasn’t made sense to buy the S&P 500. But from a kind of structural point it has. It probably will continue to be so.

[00:53:49] Alan

Do you see a risk, at some point, of a regulatory response to kind of carry trades and short vol? I’m also thinking from the perspective of deleveraging events and de-grossing. As volatility picks up, then margin calls come into effect, and margin rates go up, and it kind of amplifies the whole cycle. Is there a better way of doing it, do you think?

[00:54:14] Kevin

It’s interesting because what would be the regulatory responses is what in that world doesn’t increase margin? So being a little facetious, I think the regulatory response would be kind of more tighter limits on margin to begin with. So, you don’t get as much leverage.

I think the history of financial markets is that there are always going to be ways around that, right? It’s very difficult to control, but you could say, you know, OK, well, these are key markets. The same way that, you know, I guess we do with real estate markets, there’s a little more direct control. You could say, well, there’s key markets that we care about and we’re going to really try to control leverage there.

We understand leverage is going to leak out into other parts of the system but if we can have circuit breakers to prevent it. So that would suggest that… I mean, actually, that’s one of the things that I sort of have concluded so far, in the second book, is that maybe you have to start treating the S&P 500 more like a regulated bank or an insurance company. If it’s providing those services to the financial markets, banking and insurance, like we talked about, an unregulated bank and insurance company, we know what that behaves like.

It behaves pretty well most of the time. And then once in a while there’s a run and things crash. And so, do you have to start regulating the S&P 500 ecosystem a lot tighter (this is pretty much what you’re saying), or accept a lot more volatility flowing into the economy. That’s going to be the question facing regulators.

Yeah, maybe tighter margin is the way to go. But it seems like we’re moving in the opposite direction. I mean, every time we turn around, there are more and more levered ways to bet on the S&P 500.

I think I just read an article in Bloomberg where they’re pushing now to introduce zero DTE options on individual stocks. We’ve got it on index stocks now. Zero DTE is zero days to expiration. Now it’s a big push to do on individual stocks. So, I think the ecosystem right now, the kinetic energy is that it’s just going to keep expanding. More leverage.

[00:56:36] Alan

Well, mine was on a different side, different topic. It was more the broader economic impact. And I know it’s something you touch on in the book about monetary policy being impacted.

The Fed might be tightening, but you can source cheap funding elsewhere, albeit with a currency risk. Is that the risk with growing trade, trades of less control for central banks, or what would you say it is from an economic perspective, the obvious vol edge of the carry regime?

[00:57:08] Kevin

Well, Tim likes to say that over time that the big economic risk is just rising debt, misallocation of capital, and falling long-term growth rate. So that growth rates, over time, start close to zero. And it felt like we were maybe there.

We went to that period where real interest rates, long-term real interest rates were zero or even negative in the US, and long-term real interest rate ought to reflect the long-term real growth rate of the economy. So, it felt like maybe that’s where we were. But I think some of that was kind of artificial due to quantitative easing. But then we’ve seen real interest rates rise. So, they’re like 1.5%, 2%. So, that’s an important indicator.

What happens to real interest rates going forward is very important because if we’re right that this kind of carry regime undermines real economic growth, then you’d expect those real interest rates to start moving down. If we’re missing something, then you would maybe…

I’ve had guests on my show, Mark Mills, Peter Oppenheimer, who are expecting productivity gains in the economy to drive more like an economic boom. So, if those guys are right, then maybe those supply-side changes are enough to offset, you know, the detrimental impacts of carry and you get real interest rates staying where they are. In other words, the real growth rate of the economy holding up.

So that’s a key indicator to watch. And that’s something we’re trying to figure out, again, in our second book. How can we kind of understand the behavior of real interest rates and what are the signposts for it going forward to determine whether or not we’re back in the carry regime or where things are changing?

[00:59:17] Niels

Now, I don’t know what’s in the new book, but there’s just one thing, when I was listening to you talking just now and also trying to think of one of your early comments today, that I wanted to ask you about. It’s something we haven’t raised right now, and maybe it’s not talked about very often. It’s actually the impact of geopolitics on carry. You mentioned earlier on that the dollar played a key role.

And I’m thinking, well, if we just think back on what’s happened the last couple of years, when Russia invaded Ukraine, there were some big new things happening in terms of confiscation of central bank reserves. And you mentioned also China doesn’t recycle into treasuries as much as they did, and so on and so forth. So, I’m just thinking does geopolitics have an impact on carry?

Since we know that the geopolitical world is changing, how may that have an impact on the carry regime in general? I don’t know if you thought about it, if not, maybe it’s something to think about for the book. But I’m just curious.

[01:00:29] Kevin

Yeah, for sure it has impacted that circular flow of dollars, as we discussed, that China and the big commodity oil exporters, I think, have. It’s clear in the data that they’re not recycling those reserves back into treasuries in the same way they used to. Now, they could be doing it in a kind of a stealth way through banks in financial centers like Ireland and Luxembourg and the Caribbean. We definitely see changes, increase in treasury holdings coming from those centers. So, it’s possible that there’s some recycling going on through them.

Overall, it seems to be pretty clear that there’s less recycling. And why does that matter? Because that was a source of demand for US treasuries. It has kept US interest rates lower than they otherwise would have been. So, one would imagine that, absent that, there’s upward pressure on US interest rates, everything else being equal, and just more generally making the dollar kind of more questionable as a reserve currency. But there’s still no real viable alternative.

Beyond that, I honestly haven’t thought too much more about how geopolitics would affect the short-term rise of carry. I talked a little bit about this with Russell Napier when I was on his podcast. But, you know, his suggestion was, well, the scale of carry trades is vast, and it can overwhelm smaller markets, emerging markets. So, wouldn’t they want, over time, to try to prevent that via maybe transaction taxes or capital flow restrictions?

I don’t know if that exactly falls into geopolitics, but the world where everyone sort of agrees that open, unfettered short-term capital flows is a good thing. I don’t think that consensus is there anymore. And I think part of the reason is that it’s because of the growth of carry, because of the ability of short-term traders to move a lot of money around and move markets because of that.

So, I wouldn’t be surprised, I guess, if you see some kind of combination of controls on short-term capital or taxes on short-term capital flows to try to mitigate the scale of carry trades.

[01:03:08] Niels

Yeah. OK, cool. This was great.

This was excellent. I really appreciate both you, Kevin and Alan, for diving into what has become a really hot topic and obviously can’t wait for the next book to land at some time. Do you already have a working title, Kevin?

[01:03:28] Kevin

We do not, but we’re open to crowdsourcing.

[01:03:31] Niels

I was going to say, why don’t we crowdsource it? And people should find some of the upcoming tweets for this episode and they should reply in there to the tweets. Let’s create some social media crowdsourcing for ideas for Kevin’s new and Tim’s new book. Wouldn’t that be fun? I’m sure there’ll be some creative people out there.

Anyways, in general, I hope people have gotten some from something from this conversation. I found it very interesting, highly educational. And of course, if you feel that you’ve found something of value to take on to your own investment journey, feel free to share this episode with your colleagues, your friends. Go and leave some comments, as I mentioned. And of course, if you would take time to leave a rating and review of the show, that would be ever so appreciated.

From Alan, Kevin and me, thanks ever so much for listening. We look forward to being back with you on the next episode. And in the meantime, go and check out the show notes for this episode and all the other resources you can find on the TTU website. And of course, not least, take care of yourself and take care of each other.

[01:04:40] Ending

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