TTU120: Carry - The Good, the Bad and the Ugly ft. Kevin Coldiron

[00:00:00] Kevin

If you think about that with a carry trade, situations where you’re losing money, where you’re forced to reduce risk, that’s happening in a world where volatility is spiking, in a world where basically everyone is trying to reduce risk. So the cost of managing your leverage in that world can be quite high.

That’s the unique part of it is that the drawdowns happen at really bad times, really expensive times to have to close your positions and things can get away from you especially fast. Whereas you might have drawdowns at times where other people are not drawing down, and therefore, it may be easier for you to manage the leverage in that sort of situation. You’re not having everyone looking to reduce risk at the same time.

[00:00:57] 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 will 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 product before you make investment decisions.

Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:52] Niels

Hey everyone, and welcome back to another edition of Top Traders Unplugged where today, Robert Carver and I are joined by Kevin Coldiron, who is a co-author of the book The Rise of Carry, which we’ll be diving into today.

But first off, Kevin, thanks so much for joining us. We have very much been looking forward to our conversation. How are you doing? How are things where you are this morning?

[00:02:13] Kevin

Well, the world’s very unsettled but I’m sitting here in California. It’s a nice sunny day. So relatively speaking, doing well.

[00:02:18] Niels

Yeah, absolutely. Now before we dive into all the juicy topics that we’re going to discuss, I would like to set the stage for our conversation partly so that the audience knows a bit more about your background. Also if you’re able to, perhaps a brief introduction of your two co-authors, Tim and Jamie Lee, just so we can all frame the conversation and put the book into a better perspective.

[00:02:53] Kevin

Well, personal background, I started work, initially, at the New York Federal Reserve back in the days when the US actually tried to control the value of the dollar by intervening in the foreign exchange markets. I worked as an analyst on the foreign exchange desk there in New York. So, I got to see firsthand the power and influence of central banks early on in my career.

I ended up doing an MBA at London Business School after that and then got into the world of quantitative finance. I worked for what eventually became BGI, Barclays in London, and started off in the quantitative research team building models to take positions in markets, and then eventually moved over and set up a hedge fund business.

My Insight was, “Hey, we’ve got all these great models, we’re just using them at the moment to take long positions, but actually, there’s a lot of power on the short side. Let’s set up a hedge fund to exploit that.” I ran that business in London in the late 1990s and then realized I’d be better off doing this on my own.

I moved to San Francisco and partnered with Peter Algert, who was the head of US equity research at BGI at the time. So we started a hedge fund business in 2002, Algert-Coldiron Investors. Our strategy was long-short quantitative equities. We traded all markets around the world, developed and emerging. We were using quantitative models but kind of longer-term quantitative models, holding periods on the order of 6 to 12, 15 months so not high frequency in and out type of things, really trying to systematize the insights of fundamental analysts.

A lot of the inputs into our modeling was accounting data, but we also used some kind of volume and price stuff. I did that until 2014 and then I ended up selling my stake in the business back to Peter and since then, I’ve been teaching at Berkeley, the business school in Berkeley, and they have a master’s in financial engineering program.

Basically, the students are very highly skilled in the quant space, a lot of them have advanced degrees in math and computer science, etc. They use the program as a tool for getting into finance. So I teach a course on asset management in that program.

[00:05:34] Niels

Very exciting, must be fun for them to actually have someone teaching them that’s done it as a practitioner. Of course, I’m spoiled today because I have two authors with me who are both practitioners, which is not that often you see people write about stuff they’ve actually done in practice. So I’m thrilled about that.

In terms of your co-authors of the book, Tim and Jamie Lee, do you want to give a little bit of their background, Kevin, just so our audience knows what their background might be or angle to the book?

[00:06:03] Kevin

Yeah, happy to do that. Tim and Jamie are related. Jamie is Tim’s son. Tim, I met many years ago. He ran a consultancy called pi Economics. Tim is a macroeconomist. We were a client of his. He had a consulting firm where he would write on strategy and markets. Most of his clients were big macro-type traders and we weren’t that at all. But I really liked the way he viewed markets and so we tried to take his macro view and embed that, not so much in our alpha forecast, but in how we managed and calibrated risk in the portfolio.

Tim had been writing about the importance of carry trades I think before anyone else. He was really talking about the influence of the yen carry trade back in 2005 and 2006, and identifying that really we had entered this carry regime well before we even had that term. So when I left my firm in 2014, I called up Tim and said, “Hey, I really think all this stuff about carry you’ve been writing would make a great book.” And he said, “Well, as it turns out, I’ve already got kind of an outline and a plan to write one with my son Jamie,” who I hadn’t met before.

Jamie is a volatility trader. Tim’s got the big macro picture but Jamie has actually managed and traded in the volatility markets and now works for Jeremy Grantham, the GMO founder, (in a personal capacity) works for his foundation. So he helps on the asset allocation side and then manages the sleeve of money for him trading volatility.

So it’s a nice combination because you’ve got Jamie who really understands the guts, the microstructure, and Tim is macroeconomist, and then I fit in the middle. We talk quite a lot in the book about institutional incentives to engage in carry trades and I kind of have seen that firsthand from my perch as a hedge fund manager for a long time. So that’s the three of us.

[00:06:14] Niels

Great background and great to have three different people come together and write one book. So let’s talk about the book.

[00:08:35] Kevin

I should just say, Niels that, to be clear, of the three, I’m the least intelligent of the three.

[00:08:55] Rob

Niels, we’ve got the wrong guy on the podcast. Were the other two not available?

[00:08:59] Niels

I thought the British were the humble ones but here we have an American just saying, no exactly. Well, there we are.

[00:09:04] Rob

He worked in London for too long. That’s why.

[00:09:08] Niels

Excellent, excellent. Rob, why don’t you take the lead on diving into this book, The Rise of Carry which by the way, I highly recommend that all our listeners should get and read for themselves of course.

[00:09:23] Rob

Definitely. I find it a very interesting book as well. I’ve got a not dissimilar background. I’ve done a bit of volatility trading myself. I worked in systematic hedge funds and a long time ago, I learned some macroeconomics which I’ve, unfortunately, mostly forgotten. So, my questioning on the macro won’t be perhaps that incisive. But let’s start with the absolute basics.

Let’s start with the definition of the term carry and carry trade. We’re both in the education business as well, so whenever I try and teach my students about this, I generally start with FX carry because I think that’s the one that’s the easiest to get your head around. So, do you want to explain to us the setup and perhaps the characteristics of an FX carry trade?

[00:10:08] Kevin

Yeah, absolutely. Conceptually, a carry trade (we talk about this in the book), is a trade that makes money when nothing happens. What does that mean? It means that, let’s say in the FX world, if you borrow money in a low interest rate currency, let’s call it the yen or the dollar, and then convert it to a higher interest rate currency, let’s call it the Turkish Lira.

So you borrow at 0% and you convert it to another currency and you deposit it in a bank and you earn 10%. If nothing happens, the world stays the same, if the exchange rate doesn’t move, then you’re making that 10% yield spread. So that yield spread, that income that accrues to you if nothing happens is the carry. That’s the basic setup.

Now, that trade has certain very important characteristics. One is it is short volatility, which is basically a fancier way of saying you make money if nothing happens. So if the world stays the same, doesn’t move, volatility is very low. If on the other hand, things change, volatility emerges, then the probability of you losing money starts to grow.

Typically, these trades involve money flowing from a low-risk environment to a high-risk environment. So when volatility rises, typically the high-risk currency or asset tends to depreciate. So that trade is short volatility. In times where volatility spikes, carry trades lose money. Our definition is that carry trades always involve leverage, so it always involves borrowing.

So a long position, unlevered in say a high dividend yield portfolio, would not be a carry trade. Even though that makes money when nothing happens, you earn the dividend yield. Our definition is that carry trades always involve leverage. They’re liquidity providing; so in other words, money is flowing where liquidity and capital is abundant to where liquidity and capital are needed.

So, there’s a lot of capital and liquidity in Switzerland or Japan, you borrow there, you invest in Turkey where interest rates are higher, there’s a need for capital. So whereas carry is growing, market liquidity rises, becomes easier to trade and easier to borrow. The last feature of a carry trade is that it’s got what we call a sawtooth return pattern. In other words, long periods of positive returns punctuated by occasional large drawdowns. So, in the currency example, the exchange rate between let’s say the yen and the Turkish lira is mostly stable.

Indeed, as carry trades grow, the lira might even appreciate as money flows in. But Turkey is a risky place and when volatility emerges, you can get a sudden flight out and so you get a steep drawdown. So you get these kinds of patterns, people call it escalator up, elevator down. That elevator down emerges typically in times of crisis, so carry is a risk that is, in some sense, hard to diversify because it’s emerging when everything is going bad.

[00:13:41] Rob

Yeah, there’s quite a lot I want to unpick from that answer definitely. I guess the first thing to say is that the sawtooth return pattern, another way of describing that is negative skew effectively, isn’t it?

[00:13:53] Kevin

Correct. Yes.

[00:13:56] Rob

The other thing that’s interesting to me is the one thing that we talk about a lot on our podcasts which is the difference between volatility and risk. I think in a lot of financial markets contexts, risk is kind of thought of in a symmetric fashion. So the classic way of measuring risk is with a standard deviation, which of course, is a symmetric measure of a distribution in which a high upside is seen as bad as a high downside.

But in that FX carry example, a high upside on the trade obviously isn’t a problem, right? It would be great if the lira appreciated by a surprising amount, you absolutely love that. But generally, the risks are actually skewed to the downside. When the world gets more volatile, the Turkish lira does not tend to appreciate versus the yen.

Although theoretically, you could argue that the FX carry trade is not necessarily short risk in the general sense because some risks are good for it. But in a realistic world, it’s kind of a short vol trade.

[00:15:00] Kevin

Exactly. That’s exactly right. Yeah.

[00:15:03] Rob

Maybe we could talk about a slightly different example of a carry trade then which is more pure short vol. That would literally be something like selling VIX futures or paying variance swaps or shorting straddles in the options market, that kind of carry trade.

[00:15:23] Kevin

Yeah. If you short VIX futures, as you said, you’re literally selling volatility or selling implied volatility. That’s a carry trade in the sense that if the typical shape of the VIX futures curve is upward sloping, so the one-month forward volatility typically sits above spot volatility and so on. So, you have this term structure of volatility that’s typically upward sloping.

A way to a carry trade, in that world, would be shorting VIX futures and then just kind of rolling down the curve. So if you short a four-month VIX future, in four months, it becomes spot VIX. Spot VIX trades below four-month forward volatility so there’s that roll; the return you get for rolling down that curve is the carry.

If the world stays the same, if nothing changes, if the shape of the VIX term structure stays the same, then you make money rolling down the curve, and of course, you lose money if short-term volatility spikes. So if you were putting that trade on a month ago, you’d be losing money right now because the VIX has spiked.

[00:16:49] Rob

I was talking to somebody who did have a trade on last month, and it is now closed.

[00:16:55] Kevin

Exactly. The thing is, it may have been closed voluntarily or it may have been closed forcibly, and that’s the thing. If you’re in a leveraged position that’s short volatility, then you lose control of your future because if you lose money, you get stopped out or you’re forced to close your position. That can reinforce the movements in the short-term vicious leverage cycle that I’m sure your listeners are all familiar with.

So, yeah, that’s a pure volatility carry trade. I think it’s quite interesting. We try to explain this in the book. My son read the book, and he said, “Some of these charts, Dad, no one’s ever going to understand.” One of those happened to be one that I developed which was trying to show that if you looked, when we started our careers back in the ’80s and ’90s, at the returns to a currency carry trade strategy, they were pretty orthogonal to the general movement in volatility globally.

But in the last 20 to 30 years, the returns to a currency carry trade have been highly correlated with the sort of volatility carry trade that we just talked about. In other words, these carry trades, their risk factor has merged into (I think) a single global risk which is really centered on the S&P 500 and the VIX. So a lot of carry trades are short vol and that vol is really represented now by the VIX, I think.

[00:18:36] Rob

Yeah. We really saw that in 2008. Where I used to work, we had a fund of hedge funds business and there were all these hedge fund styles that were supposedly uncorrelated and when the metaphorical tide went down, it turned out there were an awful lot of those guys who weren’t wearing bathing suits, as the metaphor goes. Actually, a lot of their returns under the hood were basically carry-related. So the correlation was much higher than you thought it was.

[00:19:03] Kevin

Precisely. Yeah. It’s tough as a hedge fund manager. I’ve seen that myself and you have in your career and we talk about this in the book. The incentive structures of a lot of the asset management world (hedge funds in particular), make it very challenging to have a negative carry trade. You’re incentivized to have positive carry because with positive carry, you make money most of the time.

So if you can show your boss your P&L is positive. If you make money four out of five years, you collect a bonus four out of five years, your firm collects an incentive fee four out of five years. Then when you have the drawdown, the drawdowns happen. They happen during times of generic spikes in volatility where you can say, “Well, that was out of my control. Everyone’s losing money. It’s not me, don’t fire me. Nothing I could do.” It’s tough.

Those incentives matter. Those agency issues are very important and so it’s not surprising that professionals have migrated toward trades with that kind of carry profile given the way that they’re paid.

[00:20:12] Rob

Yeah, it’s interesting because Niels and I are more on the momentum end of the spectrum, which is a bit more like a positive skewed strategy, which means you have the exact opposite experience. You spend much of your time explaining to clients why you’re in a drawdown and hoping they’ll hold on for the period, the one year in five or whatever it is when you actually make money so, absolutely.

Let’s just dig in a bit more. I can understand that any leveraged trading strategy is inherently more dangerous than any unleveraged trading strategy. You’ve always got the danger that you’re going to be forced to stop out; close your positions when you don’t want to. Everyone always says that, “Oh, if only I’d been allowed to hang on for a bit longer.”

I’m sure the LTCM guys were saying that back in 1998. “If only I’d been able to hold on for a little bit longer, it would have all come back.” Obviously, you can run any number of strategies in a leveraged way. We’re futures traders here, so we’re always using leverage. We’ve got no choice. We’re inherently using leverage. What’s uniquely different about the leverage in the carry trading strategy that makes it more toxic do you think?

[00:21:28] Kevin

Well, I guess I would turn it back to what the underlying economic risk in a carry trade is, which is short volatility. So, you have a levered position, the key risk factor is what happens to volatility. In a levered position, as you said, you run the risk of being forced to close out and that means trading, regardless of impact, you have no choice.

If you think about that with a carry trade, situations where you’re losing money, where you’re forced to reduce risk, that’s happening in a world where volatility is spiking, in a world where basically everyone is trying to reduce risk. The cost of managing your leverage in that world can be quite high.

That’s the unique part of it is that the drawdowns happen at really bad times, really expensive times to have to close your positions and things can get away from you especially fast. Whereas you might have drawdowns at times where other people are not drawing down and therefore, it may be easier for you to manage the leverage in that sort of situation. You’re not having everyone looking to reduce risk at the same time.

[00:22:50] Niels

Maybe that’s the benefit of mostly being in a drawdown all the time, actually, as a trend follower, probably the only benefit I can think of right now. But I do want to pick up on this point because I think it’s important. Why would this risk be different or more toxic? I think that’s a great question. I wanted to ask you this, Kevin.

Volatility obviously plays a key role in releasing the risk of the carry trade, let’s call it that. If we go back in history, I would argue that volatility just used to be a measure. We just used it as a measure. We looked at it and it was a measure. But now volatility is in all of our models, it’s in all of our parameters. It’s a key component. So when it does change dramatically, it seems like it hurts a lot more people or there’s a lot more people who suddenly have to react at the same time.

So I wanted to hear your thoughts about this transition of just the term volatility and the role it plays in investing and maybe your thoughts on whether it’s that transition that increases the toxicity of the carry trade.

[00:24:03] Kevin

Yeah, that’s a very good point. It almost kind of edges into philosophy at some stage. There’s the first moment of returns, the first moment which is the mean and then volatility is supposed to be a function of how the return evolves. But as people trade volatility itself as an asset or an instrument, you could argue that the tail kind of wags the dog in some sense.

[00:24:35] Niels

Or a parameter, Kevin, I would say, or a parameter where it triggers us to change positio, certainly in our world, where we everything is kind of positioned sized according to volatility.

[00:24:49] Kevin

Exactly right. Let’s walk that logic through a little bit and think about maybe a risk parity type of strategy where positions are scaled according to some measure of typically historical volatility but maybe in your world, it’s forward-looking volatility. Either way, those two things are fairly correlated.

So, if whatever measure of volatility you’re using changes, your model changes, you use that to then scale your positions up or down which in turn (if enough people are doing that), actually impacts the historical evolution of the return which then feeds back into your measure of volatility.

So I do think you’re absolutely right, that’s a change, probably, that we’re only seeing I’d say in the last maybe 10 years in scale. Returns I think now, are at least in part, driven by this volatility sizing behavior by traders and by long-term investors. It’s no longer just this independent output. It’s part of the system.

[00:26:03] Niels

Yeah. Rob, I’ll let you continue.

[00:26:07] Rob

Yes. I was also thinking that maybe carry has got something in common with similar type strategies in things like say equity long-short, where you have an effect overtime where the trade gets crowded, more people get into it, and the edge in the trade gets reduced.

If you think about, say, piling into an emerging market currency that’s got a high yield, the currency might appreciate but at the same time, it’s quite likely the interest rate differential ratio will narrow because there’s going to be a massive demand for bonds issued by say Turkey, and therefore the price is going to rise and therefore the yields are going to fall and the actual interest rate differential will reduce.

So, I have this mental image of lots of people getting into this crowded theater and the marginal person coming in having to pay more and more for their ticket, but they’re still going in this, this is the thing that’s quite remarkable that people still pile into these trades.

Again, we can go back to 2007 where people were still piling into trades where they were selling protection on credit, say for basis points, for almost no premium at all, because it was completely safe and couldn’t possibly go down in price. So I wonder if that’s another characteristic of the carrier trading strategy that makes it inherently more risky.

[00:27:30] Kevin

That it’s more likely to be “crowded” in other trades? Is that what you’re saying? I just want to make sure I understand.

[00:27:40] Rob

Yeah. I think it’s more about the relationship between the… So, whenever we see a sawtooth pattern of returns, that’s probably due to a pattern of people going into a trade, the trade getting crowded, and then if anything goes even slightly wrong, because of the effects of leverage, the rush for the exits is much bigger than it would be if A – the trade wasn’t crowded and B – there wasn’t leverage on to begin with. But then I guess the other thing that’s going on is that the sort of returns available from the trade are getting smaller as more and more people pile into the trade.

[00:28:12] Kevin

I got you. The marginal investor, the one who is going to lose money first is also the one who’s come in when the yields spread, the carry is most narrow, kind of at the end.

[00:28:25] Rob

Maybe that’s actually what makes the trade more susceptible to a breakpoint, because you’ve got a whole bunch of people just coming into this trade who are earning almost nothing. So it doesn’t take much of an adverse movement for them to start losing money and having to cut their positions. Whereas the guy who has been in there for three years and has been earning a yield spread of 5%, 6%, 7%, 8%, 9%, 10% is still okay with it.

[00:28:48] Kevin

I think that’s a great point. People have talked about how it only takes one grain of sand in an unstable pile to get the cascade going. I think you’re right on that. I hadn’t actually thought about it in those terms. But the marginal investor has far less room for error in the carry trade than maybe the other trades, and given that there’s underlying leverage, that adds to the fragility. I think that’s a good point. Yeah.

[00:29:17] Rob

That quite neatly brings me on to the next thing I want to discuss (which was for me as a former sell-side vol trader), so basically a market maker in the volatility markets in interest rates for what it’s worth. One of the sections in your book I found really interesting, and I’ve honestly never seen before, was this analysis of the feedback effects of people trading options, obviously selling options to earn carry; option premiums effectively, and the effect that has on the actual level of volatility.

The subtitle of your book is The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis. So this idea of this carry trade actually suppressing volatility through the interactions of market participants is something I found really interesting. I’ve not explained it very well. I’m hoping you can explain it a bit better.

[00:30:13] Kevin

No, it’s interesting. As you were saying that, I actually was starting to think about your previous question. I think the two are linked. Selling volatility is a carry trade. If you think about the crudest way, if you’re just selling an option unhedged, it’s a bet on the implied volatility in the options price being higher than ultimately the realized volatility. So that’s a short volatility trade. You can delta hedge that as well and transfer some of that volatility risk to the counterparty, the delta hedging counterparty.

But either way, if you think about what’s happening, as more people come into that trade where they sell volatility, what effect will that have on the levels of volatility? It will push them down just like anything else. So, if you think through that process, the marginal person who enters that volatility-selling carry trade will be coming in at a very low level of volatility, volatility getting pushed down. That’s what we mean by volatility suppression.

The growth of carry trades has a tendency to push the level of volatility down, but then it also increases fragility. When you have a spike in volatility, then that margin for error and that marginal trade as you just said, is a lot less and you can get the process reversing.

What we talk about in the book (I’m kind of jumping a little bit), is if you think about what the central banks have done over the years in intervening to stabilize markets. What happens when central banks intervene? The focus is always on interest rates and QE. But at a macro level, the big impact is that it stabilizes volatility, and oftentimes volatility comes down quite dramatically after central bank intervention is announced. So, that has the effect of truncating losses for carry traders.

Carry is short volatility. If volatility spikes during a crisis, that’s very bad for carry traders. Fed intervention has the impact of capping that volatility and pushing it back down. Indeed, the expectation that the Fed is going to intervene keeps volatility at low levels generally. So, central bank intervention has helped truncate losses for carry traders in a crisis, which in turn, makes carry trades look more profitable because we never observe the full left-hand tail of that distribution.

It’s like when you’re calibrating how much do I want to do this trade, how much risk should I put in this trade, how correlated is it with other things, you’re doing that based on a distribution that’s been influenced by the suppression of volatility from central banks, which encourages more people to do the carry trade, which in turn, creates more kinetic energy for volatility in future crises, more potential for it to spike, which necessitates bigger interventions and you have this kind of ratchet process through time.

[00:33:43] Niels

It’s funny to sit here and listen to you and talk about these things, especially the currency carry trades, which are really the first ones that I can remember. It was incredibly popular in Denmark back in the ’80s and early ’90s. It was just one of those things. Another thing that people did a lot of back then was just selling straddles, especially on the FTSE.

I don’t know why, but I remember these firms popping up with these incredibly amazing looking, stable track records, and then every two or three years, they would just completely blow up. I certainly remember also, early on in my career, having been involved in just sitting there and selling straddles on the German bund hoping that it would more or less stay stable, which of course it did for most of the time, but when it didn’t, it was pretty nerve-wracking.

[00:34:36] Kevin

You’re an old-school carry trader.

[00:34:39] Niels

Oh, yeah, and now completely in the other camp.

[00:34:42] Rob

It’s like they say: “There are old traders and there are bold traders, but there are no old bold traders.” So Niels used to be bold, but now he’s old.

[00:34:52] Niels

Yeah, I definitely went from the convergent to the divergent side of investing, that’s for sure. It’s also funny actually in a sense that I think we’ve had maybe (I don’t know if you can say that), but certainly one of the ultimate carry traders we’ve actually had on the podcast is name that might be familiar to you, Kevin, that’s Nick Leeson. He was on the podcast. For various reasons, in a sense probably not that he planned, but he really did become the ultimate carry trader selling all his straddles on the Nikkei back in the ’90s I think it was.

But I wanted to go somewhere slightly different, although it could involve the central banks, as you kind alluded to also. But I wanted to ask what your thoughts are in terms of the role that carry trades may play in financial bubbles. Are there any relationships? Do they create the bubbles? Do they make them bigger? How do you see that?

[00:36:00] Kevin

We talk about the world entering what we call the carry regime. The carry regime is a world where carry trades aren’t just done in foreign currency markets, but they grow. They’re done in the options markets. We think of private equity as essentially being a carry trade, buy-to-let property being a carry trade. We see them everywhere. What that means is that, again, going back to the characteristics of a carry trade, what are they? They are leveraged trades that provide liquidity.

So in a world where carry trades are expanding and growing, debt is growing, leverage is growing, and so is liquidity. So in some sense, as that world expands (if you will, the bubble)… So, the short answer to your question is yes, I do think they’re involved in financial bubbles and I’m trying to describe how we see the mechanism.

So, in that world where the bubble or the carry regime is expanding, initially, that looks like a pretty good world because liquidity is enhanced. By liquidity, I mean the ability both to access capital, so to borrow, and also to transact in financial markets. So, both those things are improving and the world looks good. At the same time, it’s increasing levels of debt which is putting downward pressure on interest rates and inflation. It creates this illusion that certain financial assets are almost as good as cash, money substitutes.

So you have a deflationary world, low interest rates, people aren’t very attracted to holding cash because it yields nothing. But financial markets are very liquid and easy to trade. So, they substitute cash holdings for holdings in financial assets. Here I’m thinking about money market funds, or corporate bond ETFs, a variety of things that because they seem very liquid and they offer higher yields are good money substitutes.

But remember, all this carry trading is short volatility. So when volatility spikes, carry trades lose money, risk emerges, and people no longer are happy to hold those money substitutes. They no longer see corporate bond ETFs as a money substitute. They no longer see money market funds. They just want treasuries or they want bank deposits. You get a flood out of these money substitutes back into true cash.

I basically see that carry as helping accelerate financial bubbles through this creation of helping grow leverage and liquidity, but then also making the contraction of the bubbles more severe through this mechanism of flooding out of money substitutes when liquidity disappears. Another long answer to a question, but this mechanism is quite important, actually. I really think that’s what we’ve experienced in the last 30 years.

2020 was quite a clear example of that, where all the sudden, no one wanted to hold money market funds or short-term bond ETFs and I think that’s why it was absolutely critical, in the sense of it showed just how important this money substitute effect is when the Fed said they were going to buy corporate bonds because they understood those things were being packaged as basically money substitutes. If they didn’t underpin that market, there wasn’t going to be enough money around to meet the demand.

[00:40:12] Rob

They were actually buying ETFs as well which surprised people. They weren’t even buying the underlying bonds. Whether they were buying ETFs because they felt that was the most efficient way of doing it or whether that was a specific area of the market they were trying to fix, I don’t know, actually.

[00:40:30] Kevin

I think it’s both. The discounts to NAV on some of those corporate bond ETFs were massive. Yeah, I think they were trying to do both.

[00:40:41] Rob

Let me ask you a question that you can answer with a short answer, Kevin, or at least try to. Are we currently in a carry regime? Yes or no?

[00:40:51] Kevin

I think we’re transitioning. I think we still are in the carry regime, but we may very well be moving in the final phases of it. A lot of carry trades haven’t been that profitable in the last decade or so. Currency carry trades have not been that profitable, even volatility selling in the S&P 500 hasn’t been profitable, depending on how you set it up, in the last five years or so.

We do say that the end of the carry regime will probably come through some form of inflation, which we’re starting to see. So, I think we could be in the early phases of maybe transitioning out of the carry regime. If you think about in the past, 2008, 2020, what has the macro environment looked like when there was a big central bank intervention? Typically, low inflation.

Now, if we had a market crisis, and you’ve got inflation already at 7 or 8%, and the Fed intervenes, then all of a sudden, it doesn’t become crazy at all to see inflation expectations really becoming unhinged. Because it’s one thing to pump a ton of liquidity, print a lot of money in a world where inflation is zero. You do that in a world where inflation is 7 or 8%, and maybe you really do push yourself into a completely different world, a different regime.

Now, I’m not saying that’s going to necessarily happen, but I don’t think it’s out of the question by any stretch.

[00:42:26] Rob

Yeah. One of the things we talk about quite a bit is the fact that central banks, especially over the last 15 years, ostensibly, central banks are there to help the man on the street or the woman on the street. But, of course, generally, their interventions since 2008 have mostly been helping Wall Street, the financial economy rather than the real economy.

So, I guess that’s an example of that dilemma that the tools that central banks have and the objectives they have, actually even without going forward like right now, as a central bank, there are clearly areas of the real economy that are still in a pretty bad state. And yet, ostensibly, inflation is here. The tools we’ve been using to help the real economy, we now need to reverse in a way that will probably reduce asset prices, probably reduce inflation, but could do untold macroeconomic damage.

I’m getting off-topic. Let me try and steer us back to carry. So I guess, in a similar vein, what’s the kind of mechanism or transmission mechanisms by which carry (which we’ve talked about, really as something that happens in the financial markets). Most people on the street aren’t going out and doing carry trades. There aren’t housewives in Iowa doing straddles on the German bund, like Niels.

What are the transmission mechanisms by which carry can change the economy and potentially damage it and cause problems if, for example, we have one of these sawtooth down movements in carry which it sounds like you’re seeing happening now?

[00:44:00] Kevin

I think the main mechanism is through the S&P 500, which we say has become the center for the global carry trade. The volatility of the S&P 500 is a carry trade, which it is. It behaves in that sawtooth return pattern, escalator up, elevator down. That basically means the S&P 500 follows that same pattern.

[00:44:21] Rob

Let me stop you there, Kevin, because I can see the direction you’re going in. I’ve obviously asked the question wrongly. So that’s kind of the pure wealth effect, which is potentially important, because households do have stocks on their balance sheets. But in your book, you actually talk in more detail about the creation of money within the banking system and how that’s related to carry. So maybe I should have been clearer in saying that that’s the question I want answered.

[00:44:46] Kevin

Okay. I was going to say that we claim that the flow of causality is from the S&P 500 to the real economy as opposed to what we’re typically taught which is that the stock market reflects what’s going on in the economy. We think the economy reflects what’s going on in the stock market.

I would argue that’s more than just a wealth effect, because it triggers central bank intervention, it triggers exactly what you just talked about, the creation of money and the impact on inflation. So I would argue that the S&P 500 is the global carry trade when it has drawdowns, when it has this negative skew. There’s the wealth effect also forcing the hand of the central bank, leading it to intervene and create more liquidity and potentially more possibility for inflation down the road. So that’s how we see the carry trade flowing into the real economy.

[00:45:51] Rob

Okay. What about extending that model to cross-border flows? What effect does a carry trade have in terms of cross-border flows, both pure money flows but also in terms of investment?

[00:46:02] Kevin

Yeah, it’s kind of fascinating. We’ve talked about the currency carry trade in very trader terms because we’re all traders. But increasingly, we see this kind of carry trade operating at much longer horizons. So you get Chinese firms issuing dollar debt and then converting that to RMB and in some cases, just lending on the RMB. But in a more macro sense, you get firms issuing low-interest rate dollar debt, converting that to their local currency, and then using that to invest in projects that earn local currency cash flows.

So the acceptance, the willingness to accept that currency risk, that volatility risk, allows for a whole range of projects in higher interest rate countries to get done where they wouldn’t have got done if they had to be financed at higher local interest rates. So that’s the “good part” about carrying the sense that it’s creating (while the carry regime is expanding) more growth, more money flowing to emerging economies, more cross-border flows. But then it introduces that exchange rate, that volatility risk into that cross-border flow mechanism which makes it more fragile.

When we get these volatility spikes, then you get those flows that can reverse quite quickly and you can get contraction in growth outside the US or outside low-interest rate currencies very quickly. Volatility in emerging market currencies, that’s one of the indicators that we said in the book could point us toward, are we moving out of a carry regime, if we start seeing kind of extreme volatility in emerging currencies, which you could argue for certainly in the case of Turkey, we have; now Russia.

So, I think that’s another indicator that the stability of the currency regime is reducing quite a bit these days. I think we are in a transition phase from that point of view. But yeah, and the carry regime does have a big impact on cross-border flows, for sure.

[00:48:20] Rob

One question I was going to ask in a bit, but I’ll ask now if that’s okay with you Niels. You’ve given me one example of when the carry trade is a good thing. It’s building power plants and dams, perhaps overseas that otherwise wouldn’t get built. Can you give me any other examples or are you just so down on the whole thing that that’s the only one you can think of?

[00:48:40] Kevin

Well, the example that I think is most easy for a lot of people to understand but again it might end up being a negative is there’s big growth in cross-border mortgages in Europe, right? When the Swiss agreed to peg the Swiss franc against the euro, there were a lot of people who took out mortgages in Swiss francs and used that to buy houses in Hungary and Poland. A lot of people could buy houses who couldn’t afford to buy houses if they had to pay local interest rates.

Unfortunately, the Swiss changed their mind and their currency appreciated by 25% overnight. So you had a whole range of people who no longer could afford to pay back their mortgage. So I suppose in the end, that ended up being not a good thing because they then had to bail out or they had to default.

So I suppose in the end, I’m suspicious of the quote “good side” of the carry trade because I suspect that the full risk of exchange rates or volatility isn’t embedded in the calculations of the people who are taking out the low interest rate loans and using them to build power plants. Maybe they are. Certainly, some people are sophisticated enough to do that but I suspect in the end, that risk isn’t fully embedded into the projects.

[00:50:03] Rob

So you don’t take the Greenspan-esque view of 20-odd years ago, which is that derivatives are good because they allow risk to be transferred between people who don’t want the risk to people who do want the risk.

[00:50:13] Kevin

I’m sure there’s plenty of that that happens. But I think what we’re talking about is a world that’s moved on dramatically since then. Selling options is a form of conditional leverage. Like you’re saying, I’m going to use my balance sheet in certain conditions. If the put finishes in the money then as a seller of the option, I have to be prepared to use my balance sheet to make good on that.

So, there’s just a whole bunch of contingent liabilities out there in the system related to derivatives that we really don’t have a handle on. I just can’t believe all those contingent liabilities are fully funded or won’t result in risks emerging that haven’t been properly priced. So yeah, I guess I’m a bit of a skeptic on the Greenspan view of the world.

[00:51:12] Niels

I want to pick up on the topic that you’ve just discussed here between the two of you. I think it’s pretty clear that there are a lot of forces out there who really cheer for carry, not least, central banks in their action. But also, if we go back and we look at, and I don’t know exactly when we can pinpoint the beginning of it, but clearly, guidance from central banks and narrative and conditioning of investors have become more and more clear that that’s taking place. It underpins the whole carry world.

Of course, carry in itself is something that I think humans can relate to because it’s this thing about you can make money by doing nothing. What could be better than that? Actually, I’m very worried of what could happen next because of all of this, because of the actions that’s been taken to “stabilize markets”. The narrative that we’ve been told and I think some people who maybe haven’t been in the market as long as we have, have only seen this fit put and buy the dip, and all of that stuff, and then on top of that, you can add crypto and all of that stuff.

So what I’d like to hear from you is, if we think that the carry regime is starting to lose its grip (and I don’t know if there’s been other periods and historically, you may know this, Kevin, but there’s other periods where it’s been definitely a carry decade or two and then something else comes),but I’m interested in your view as to what comes after a carry regime? What does that regime look like? I’d love to hear both of you, what you think.

[00:53:08] Kevin

I think the central contradiction of the carry regime is that central banks appear to be all powerful, when in fact, their grip on the markets is slipping away. So in the short term, when they intervene, they stabilize markets; buy the dip works. More people do buy the dip. More people do carry trades. But that’s just requiring a bigger and bigger and bigger role for the central bank.

When we have a crash where the central bank isn’t able to stabilize volatility, let’s say we have a world where we’ve got 7% inflation, the market crashes, central banks intervene, they pump a lot of liquidity and markets continue to go down. Then you have a really dangerous situation where you’ve created a huge amount of potential inflation, you haven’t stabilized the markets, and I think that very possibly will happen in the next crash.

We’ve got a world where everyone’s going in thinking that central banks are all powerful, but in fact, they’ve created the tinder for a fire that they won’t be able to put out. So, had they actually been less interventionist, they might have retained their influence. But I think they’ve now set up a situation. I think about the equity market. Since 2020, what’s happened to credit spreads and what’s happened to the VIX? Credit spreads, relative to their history, are very, very low.

That makes sense because the Fed has said, “Hey, the credit markets are now under our protective umbrella.” Whereas the VIX, the measure of equity risk, has not fallen back in the way it typically does after a crisis, which suggests to me that markets worry that equities are not under that protective umbrella. I think in the next crash, that is going to be tested.

The credit markets are going to expect to be supported and then if the equity markets aren’t, it leaves them in a politically very dangerous situation, because it’s like, “Hey, how come you bailed everyone else out but not the person who’s put money in their 401k?” So I think the next stage is whether or not the Fed will make good on that explicit promise to bail out the equity markets.

If they don’t, then you really get an eruption of volatility combined with higher inflation. So I think that’s the next stage. I think a non-carry regime world is going to involve much higher and sustained higher inflation and a loss of credibility of the central bank, which ultimately might mean rethinking the role of a central bank.

[00:56:06] Niels

Before I hear from Rob, just because maybe I don’t know financial history as well as you do, Kevin, but would you say that there has been periods like this where you could classify it as a carry regime and it’s come to an end? Or would you say, historically, it’s probably more like high or low inflationary period that kind of describes this because maybe we didn’t think in the carry terms back in the ’70s or back in the ’40s or whenever we last had some “crashes” that took a while to overcome?

[00:56:47] Kevin

Well, when you were saying your question, initially, there was a point I wanted to make which is that carry, I’m talking about it in very negative terms and I should be careful because some amount of carry is absolutely critical and socially good. Banks do carry trades. They’re levered positions that provide liquidity and we need that.

Insurance companies selling insurance is also a form of carry trades, and that makes everyone better off if a well-capitalized insurance company sells. Insurance allows us to transfer risks, etc., and even derivatives to some extent can serve that purpose. So a certain amount of carry trading is good. It’s when it becomes too big that it creates the fragility that we’re talking about.

So if we look through the history, our view is that we really started the carry regime either in 1987 or 1984 with the introduction of S&P 500 futures and that accelerated in 1998. If we look back before then, we didn’t have the integration of global markets, we didn’t have derivatives. It was much harder to do carry trades. It was more limited just to banks. So I don’t think we’ve seen the carry regime, in the past, that we’re experiencing now. I don’t think it’s in the data before the ’80s.

[00:58:16] Niels

Right. That actually makes it even more dangerous, in my opinion, because most people will not have seen this, like most people who now manage large sums of money have never experienced what it’s like to manage money in an inflationary period. So it kind of ties in together.

Rob, what are your thoughts on this? I know we have to slightly start to think about winding down. We’ve already kept Kevin more than an hour.

[00:58:42] Rob

I recently reread the book, a biography of Jesse Livermore who, of course, as you know was a stock trader in the early part of the 20th century. I immediately thought 1929, because going into 1929, the amount of leverage that people could get on stocks was even higher than today. You could go out and buy stocks with like 20 times leverage, it’s absolutely crazy.

The central bank definitely did not intervene after that and in fact, arguably, the US central bank prolonged the depression because they were very much believers in “sound money,” so they were not interested. Worst case scenario is that we are looking at the 1930s. Against that, there are a couple of hopefully bright spots. One is that governments stopped looking to central banks to do all the work that fiscal policy ought to be doing as well. I think that’s a big problem.

I think governments have sort of allowed the central banks to be the people who are always bailing them out, which means they don’t have to do unpopular things with taxes and so on. So, maybe the bounce to monetary fiscal policy will become better. Whether there’ll be time to kind of sort that out if we get a crash, I don’t know, but that’s what I would hope happen, that we shouldn’t just be relying on the Fed.

The second thing, really briefly, is I do wonder if this is more of a US story than a European story, because the number of stocks in household balance sheets I think is higher in the US. For example, in the UK, a lot more pension plans and more heavily weighted towards government bonds for example. Stock ownership is generally lower in most European countries than in the US. Obviously, what happens in the US affects the rest of us anyway.

But I do wonder whether that transmission mechanism is potentially more of a problem in the US than it isn’t in this country. I think in this country, the link between, for example, the UK and Denmark have some of the highest levels of household mortgages than any other country. So in those countries, what the central bank does in terms of the transmission mechanism on mortgage rates is potentially more of an issue. There you go. That’s my brief answer to your question Niels.

[01:01:00] Niels

Any comments to Rob’s thoughts there, Kevin, before I give you my last question?

[01:01:07] Kevin

I was going to say one thing earlier when he mentioned what the central bank is trying to do with their intervention in terms of supporting the man on the street. I think that’s absolutely right. I call it trickle down insurance. It’s like they’re trying to ensure that people don’t lose their jobs; the living standards are maintained. The only tools they have to do it are through the financial markets, which is multiple steps removed from what they end up doing. This I think circles back to what Rob said.

A better system would be to say, what are we trying to insure and let’s insure it, and then let the financial markets do their thing, and to step back from the Fed having to be the market maker of last resort. If we decide, actually, no, we need a market maker of last resort because we have an asset-based economy so we need someone to support markets, then maybe the Fed or central banks should start trying to charge a fair price for that support.

Banks have deposit insurance. They have to pay a premium to a deposit insurance fund. You could argue they don’t pay enough, but that set aside, that mechanism, that principle is in place. They understand they’re getting insured and they’re paying for that insurance? If the Fed is playing the role of market maker of last resort, they’re insuring liquidity, then financial market participants ought to pay for that.

You could say, “Well, that’s going to mean less liquidity.” And I would say, “Yeah, that will mean less liquidity, but it just means it’s more fairly priced.” We’re subsidizing liquidity, the central bank is subsidizing liquidity, and therefore, people are going to rely on it more because it’s cheaper than it should be. So maybe we can move to a world where we insure what we care about as a society directly, don’t rely on the central bank to do it, and then what the central bank does, have it charge a proper price for it.

[01:03:17] Niels

Interesting, interesting. Actually, also, I think that if you go back in history, you will probably find that we go through these periods where we have strong central banks and weak politicians, and then it reverses and suddenly, it’s the central banks that’s the weak hand. Maybe we just haven’t seen that for a while and perhaps that’s coming.

Final question, Kevin. Is there going to be a sequel? Let me propose a title, The Fall of Carry. Is that something that you’re working on?

[01:03:44] Kevin

It is something that I would like to work on. Tim and I and Jamie and I have talked about it. So, I’m hoping to spend really the next few months after my class at Berkeley wraps up in a couple of weeks to put together an outline for it. We have talked about that, perhaps, The Fall of Carry being the sequel. So I’m hopeful that that’ll work out.

[01:04:09] Niels

Well, I’m not going to claim copyright on that so you can have a Kevin it, don’t worry.

[01:04:13] Kevin

There’ll be an acknowledgement for sure.

[01:04:14] Niels

Oh, yeah, of course. I’m sure. Excellent. I think we’re going to slowly wrap up a fascinating conversation, Kevin. Thank you so much for being on the podcast and sharing your thoughts and insights. It’s been incredibly interesting to learn about this whole rise of carry and what it really means.

As I said before, it’s a must-read book. I think I told you this as well, Kevin, that I release usually once a year my ultimate guide to the best investment books of all time, and definitely, this will be in the next issue, not that it means a lot, but there we are. Any final thoughts you want to leave the audience with, Kevin?

[01:04:54] Kevin

I just wanted to say thanks to both of you guys. Rob contacted me when the book came out and we had some good conversations and I’ve listened to your podcast and I think it’s excellent. So I really appreciate you having me on and asking questions and being polite with my long-winded answers. So yeah, I’ll leave it at that and I wish you all the best. I wish you just the right amount of volatility in your portfolio.

[01:05:26] Niels

Oh, yes, absolutely. That’s always good to have. To all of you listening today, I hope you were able to take something from today’s conversation onto your own investment journey. If you did, please share these episodes with your friends and colleagues and send us a comment to let us know what you want us to bring up in terms of topics on the upcoming conversations with industry leaders in the world of finance and investing.

From Rob and me, thanks so much for listening, and we look forward to being back with you on the next episode of Top Traders Unplugged. In the meantime, go check out the show notes for this episode and all the other resources you can find on the website and not least, take care of yourself and take care of each other.

[01:06:08] Ending

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