Carry Trade Unwinds
The Federal Reserve’s current QE program consists of buying $85 billion in bonds, (mostly debt of the U.S. government and mortgage bonds) every month in order to keep interest rates lower than they would be without Fed intervention, believing that suppressed interest rates will stimulate the economy. This suppression lowers the return on investments across the entire market, leading to what is called financial repression, as we’ve discussed in prior newsletters. This financial repression forces investors to take on more risk than they would otherwise choose in order to achieve investment return requirements. This is especially true for pension fund managers such as CALPERS and endowments.
One technique employed to boost returns in a suppressed environment is the carry trade. You’ve probably heard this referred to in the news lately with respect to the yen as Japanese exchange rates and the Nikkei index moved around dramatically. This is an example of how the yen carry trade works:
An investor borrows 1,000 Japanese yen from a Japanese bank, converts the funds into U.S. dollars and buys a bond in USD for the equivalent amount. In this example, the bond pays 3.5% and the Japanese interest rate is set at 0%. The trader stands to make a profit of 3.5% as long as the exchange rate between the countries does not change. Recently many have anticipated the yen to weaken against the dollar, which would serve to increase returns even more. Professional investors often use this trade because the gains can become very large when leverage is taken into consideration. If the investor in this example uses a common leverage factor of 10:1, then he/she can stand to make a profit of 35% rather than 3.5%. But as always, there is a catch.
In the past two newsletters we discussed how leverage affects returns. We showed how by borrowing 90% for a home mortgage rather than 80%, a homeowner’s gains are amplified when the home’s price increases, but the losses are amplified as well if the home’s price falls. Here’s a quick recap of how leverage/borrowing affects returns to refresh your memory, in case you’ve yet to have your morning cup of Joe.
|
Total Amount |
Up |
Up |
Down |
Down |
|
| Borrow |
Invested |
10% |
20% |
-10% |
-20% |
| None | $ 1,000.00 |
10% |
20% |
-10% |
-20% |
| 10% | $ 1,100.00 |
11% |
22% |
-12% |
-23% |
| 20% | $ 1,200.00 |
11% |
23% |
-13% |
-25% |
| 50% | $ 1,500.00 |
13% |
28% |
-18% |
-33% |
| 90% | $ 1,900.00 |
15% |
34% |
-24% |
-43% |
The chart above illustrates the benefit and risks of borrowing to enhance returns. It assumes a 5% interest rate on amounts borrowed. By investing $1,000 and borrowing an additional 50% in order to invest a total of $1,500 in a security that returns 10%, an investor can increase their returns 30% from 10% to 13%, after paying 5% interest on the borrowed amount. The pain from losses is exaggerated as well, if that same investment losses 10%. Rather than just losing 10% from the original amount invested, the investor will lose an additional 80%, to lose a total of 18% on their original investment.
Now back to the carry trade. After Fed Chairman Ben Bernanke’s comments concerning potential tapering of QEInfinity in the nearer-than-expected term, bond yields immediately began rising. When bond yields go up, prices go down, so in our example above, the leveraged buyer would experience significantly greater losses due to their leveraged use of the carry trade, thus the rapid unwinding which meant fevered selling of the bonds they’d bought using the borrowed yen, which only exacerbated the downward spiral of bond prices. Oy vey!
Bottom Line: Financial repression forces investors to take on more risk that they would otherwise in order to generate reasonable returns. This increased risk taking results in more volatile markets.
