Carry Trades and The Failure of Macro Economics:

The Yen and Dollar Carry Trades, and The Creation of the World As We Know It Today.

1/28/2016

This Crisis Note has been in my head since 2006, ever since I spoke to Kaupthing Bank ( when I was looking for capital or a platform to start my own Broker-Dealer), and researched Carry Trades to understand the Icelandic economy. Many parts of this discussion are in my prior Crisis Notes.

In this Note I am consolidating and augmenting them, and am attempting a comprehensive, and hopefully definitive, analysis of Carry Trades.

Carry Trades

“Carry Trade” is the term given to borrowing money in a low yielding currency (i.e. country), and investing the proceeds in the currency and assets of a higher yielding country, thereby earning a net spread, or carry.

Carry trades should never exist, as the economic concept of “Interest Rate Parity” should prevent any arbitrages from occurring. However, they do exist and are the most powerful force in Finance, as they thwart every attempt by Central Banks to conduct monetary policy. The world as we know it today has been sculpted by Carry Trades.

I do not understand why Economics (the field) and Economists have not modifed their theories and macro economic policies to incorporate Carry Trades. My assumption is that, since carry trades should not exist due to no-arbitrage assumptions, economists think that they can be ignored, and happily go about using their single-economy Keynesian models to manage policy. This, in spite of many of their colleagues joining hedge funds that implement the carry trade, with the word "Macro" in their investment style.

In one of my incomplete 2009 Crisis Notes, I attempt to rewrite Macro Economics, and indentify The Shah Theorem:

When One Economy Enters a Liquidity Trap, All Monetary Policy Fails Globally.

The primary result of Central Bank policies, as executed by Carry Trades, is to export inflation to other countries, as Asset Inflation.

In crime solving, they say, “Follow the Money”. This also applies to understanding financial markets. Without an understanding of the Carry Trade, investors cannot have an understanding of financial markets and risks, and functions such as Risk Management cannot be performed.

Carry Trades in the Press

I have been talking and writing about the relationship between the Yen and US Financial markets since 2006, and have discussed the US Carry Trade at length at many points in my Crisis Notes as well. As I have discussed many times, the deleveraging of the Great Financial Crisis resulted from an unravelling of the Yen Carry Trade, more than anything else.

Forbes, on September 4, 2014, finally had an article on Carry trades, to discuss the impact they were having on Emerging Markets. I have never seen any in-depth discussion of Carry Trades in the WSJ, Barrons, or the NY Times, although the FT does periodically refer to it, and David Pilling is well aware of it.

http://www.forbes.com/sites/investor/2014/09/04/carry-trade-the-multi-trillion-dollar-hidden-market/#739c63a0761c

Most discussion of Carry Trades (and Samurai bonds) occurred in the 1990s, especially after Tiger Management blew up in 1998 (discussed below). However, most of today’s current market participants, especially in the US, appear to be unaware of it. Most economists seem to be oblivious too.

Most economists that study the Yen and Japanese Financial Policies do so in the context of why Japan cannot create inflation, Liquidity Traps, Japan's Lost Decade(s), and Japan's fight against Deflation. Very few make the connection to the Carry Trade.

http://www.nber.org/chapters/c0092.pdf

Paul Krugman is one economist that is perceived to be a Japan Expert, and he has discussed all the topics listed above, and the Carry Trade, but once again, has not connected the two.

http://web.mit.edu/krugman/www/jpage.html

http://www.slate.com/articles/business/the_dismal_science/1999/11/tigers_tale.html

Prior to 2012, the Yen, or Japan, were rarely mentioned in the Wall Street Journal or on American business TV, or acknowledged by economists, displaying American belief and arrogance in the American economy being the dominant global economy, and thereby being isolated from other global forces. As Paul Krugman points out, most economists in the 2000s, including Ben Bernanke, believed the Business Cycle and Macro Economics to be “solved”.

During the Great Financial Crisis, Australian newspapers and economists (especially Gerard Minack) were far more keenly aware of the underlying economic events than American papers and TV. There has been some progress on awareness of Yen (it now shows up on TV sidebars nowadays), with journalists still ignorantly identifying it as a ‘Safe Haven’ on days the markets are selling off, as opposed to THE cause for movements in US Stock markets.

The Yen and Dollar Carry Trades

The original modern Carry Trade was the Yen Carry trade, deployed to great effect in 1994 by Julian Robertson of Tiger Management. It is quite likely that George Soros and LTCM were also using this strategy – they all lost money at the same time – but there is very little information available publicly. This trade is considered to be the most profitable trade in the history of hedge funds - borrowing money in Yen at very low interest rates, and investing it in other countries, initially the US, but soon every other market.

The Yen Carry trade has not stopped funding the world’s productivity (or excesses) since then. In addition, we have also enjoyed periodic episodes of Dollar Carry Trade, and more recently to a minor extent, Euro Carry Trade, as both the Fed and ECB have effectively cut rates to zero. There are other countries with zero or negative interest rates, but their capital exports are not very scalable, so I won’t discuss them at this time.

All three major central banks have also embarked on Quantitative Easing to further increase money supply, in response to entering Liquidity Traps, providing more fuel for carry trades.

Due to the high leverage involved in Carry Trades, periodic periods of nervousness have led to the withdrawal of Carry Financing, leading to massive selloffs in Global markets: Leveraged Asset Growth comes hand in hand with Leveraged Downside.

Most periods of apparent de-correlation between Yen and various assets can be explained by augmentation by the periodic US Carry Trade, as well as Samurai Bond supply, which can dominate at the margin, but changes the Yen/$ currency rate.

The following chart shows the policy rates of the Bank of Japan (Unsecured Overnight Call Rate), The Federal Reserve Bank (Fed Funds Rate), and the European Central Bank (MRO – Main Refinancing Operations Rate).

Source: Bloomberg, MBS Mantra, LLC

1993-1998: The Yen Carry Trade

This was the period that made the Yen Carry Trade both famous and infamous.

The history of the Yen Carry Trade begins in the late 1980s, when, due to unconstrained money creation, Japanese asset prices appreciated greatly, and were part of a “bubble” economy . Subsequent deregulation of the banking globally, and Samurai bond issuance rules in Japan (which I discuss in the Samurai bond CN) also played pivotal roles.

In 1989, The BOJ tightened monetary policy and raised its policy rate, continuing into 1990. In 1990, the bubble burst, and the Nikkei went from 38,915 to a low of 20,221 in 9 months. In 1991 and 1992, asset prices collapsed, resulting in large qualities of Non-Performing Loans (“NPLs”) at Japanese Banks.

https://en.wikipedia.org/wiki/Japanese_asset_price_bubble

In a textbook Keynesian response to a financial crisis, the BOJ started cutting rates again, to allow banks to earn their way out of the crisis, and resulting in the creation of many ‘zombie banks’.

Japan’s policy rate crossed the US policy rate at 3% in October 1993, setting the stage for the Yen Carry Trade.

When, in March 1994, the US began to RAISE rates, following a recovery from the 1991 recession, the Yen Carry trade started in earnest. This resulted in a weakening of the Yen, a jump in Samurai bond issuance, and a change in trajectory of the S&P Index in November 1994 (a “hockey stick”), starting a rally in US markets that continues to today, with interruptions in 2000 and 2007.

I thus define a new Indicator: The Yen Carry Indicator ("YCI"), which is the Fed Fund Rate minus the BOJ Call Rate.

A number of important trigger events occured in this period, that are represented on the charts that follow as vertical lines with the following legends:

A: October 1998 - Yen Policy Rate Crosses US Policy Rate, signalling the availability of Carry Trades

B: July 1997 - Asian Crisis starts, with the failure of Thai markets

C: November 1997 - LTCM Peaks and begins failing

D: August 1998 - Russian Crisis Starts

E: September 1998 - 9/23 - LTCM is bailed out; 9/28 - Fed Funds are Cut

F: October 1998 - 10/7 to 10/8 - Tiger Management loses $2BB in one day; $5BB since 9/28

Initial Funding of the Yen Carry Trade was through Samurai Bonds

Prior to October 1993, Samurai issuance was sporadic. However, starting in October 1993, Samurai issuance increased dramatically, with $471mm being issued in that month. From January 1994 to January 2002, there was no month without Samurai issuance, with many months with greater than $1.5bb being issued. Issuance slowed as the Asian financial crisis was triggered, but did not subside in 1997. After the US cut rates in 1998, after LTCM and the Russian Crisis, Samurai issuance slowed drastically. Large scale Samurai issuance resumed in 1999 after the Fed raised rates, while the BOJ cut rates once more to 0.1% , and also embarked on Quantitative Easing (“QE”).

I recently finished a Note about the Samurai Bond Market, which give more details about this market.

Between 1994 and 2000, $39bb of Samurai bonds were issued! Since the majority of the issuers were US financials, and many of their bond liabilities could count as capital, these issues should have allowed banks to greatly increase their balance sheets as well as US money supply, and facilitated margin lending.

In addition, a Hedge Fund’s prime broker could easily borrow in Yen from Japanese banks, as Japanese money supply had expanded while Japanese C&I lending had not, resulting in excess non-earning deposits. (Japanese banks in the 1990s would go as far as depositing their deposits in accounts at other Japanese banks to earn a return, in addition to continuing to make loans that had no hope of repayment.) I have not yet figured out how to identify and measure the size of this more direct Yen Carry funding.

The Role of Tiger Management (and other "Macro" Funds)

It had been known that Julian Robertson of Tiger was using the Yen Carry trade, and was the largest Marco Hedge Fund at the time, and that he was placing leveraged bets, but until Tiger blew up in the wake of the Russian and LTCM crises, the magnitude of the importance of the Yen Carry Trade, and Tiger, has never been quantified.

Quoting from the Paul Krugman link earlier in this post,

Tiger Management, until recently the largest such fund in the world. In its heyday in the summer of 1998, Tiger had more than $20 billion under management, considerably more than George Soros' Quantum Fund, and was reputed to be even more aggressive than Quantum in making plays against troubled economies. Notably, Tiger was perhaps the biggest player in the yen "carry trade"--borrowing yen and investing the proceeds in dollars--and its short position in the yen put it in a position to benefit from troubles throughout Asia. But when the yen abruptly strengthened in the last few months of 1998, Tiger lost heavily--more than $2 billion on one day in October--and investors began pulling out. The losses continued in 1999--from January to the end of September Tiger lost 23 percent, compared with a gain of 5 percent for the average S&P 500 stock. By the end of September, between losses and withdrawals, Tiger was down to a mere $8 billion under management.

http://money.cnn.com/1998/11/02/companies/tiger/

From the link above we know the following:

- Tiger lost $5.5B between September and October 1998

- Tiger lost $2.1B in September 1998

- Tiger lost $3.4B in October 1998

- Tiger lost $2BB in one single day in October

- Tiger had 5.5:1 leverage

Here is what happened:

From the data, we know that the $2B loss probably occured on 10/7 to 10/8, when the Yen/$ moved from 130.03 to 121.3. For Tiger to lose $2B on an $8.73 move in Yen, he must have been short $17.46BB in Yen, or Y2.27T! Since the S&P also sold off on this day, part of Tiger's losses probably also came from the long investments, which would imply a smaller Yen short position.

S&P volume was typically around 600mm in the periods prior to this volatility. From 9/23 to 9/30, SPX volume increased to around 700mm, and from 10/1 to 10/7 was between 700mm to 800mm. On 10/8/98, SPX volume spiked to 1.159B shares.

Between 10/7 and 10/8, 250,800 extra shares of the SPX traded over the prior days, with an 11.24 point decline for the day. These shares imply a $2.818B loss on the SPX, on an invested amount of $243BB in the SPX.

Looking at the 9/23/98 to 10/7/98 period, Yen/$ went from 135.5 to 130.03, apparently losing $2.1B for Tiger. This implies a short Yen position of $11.487B or Y1.55T. In this period the S&P was also selling off, while bonds were rallying, suggesting that Tiger's short Yen position was invested in the Equity Markets.

These data points suggest that Tiger was responsible for 25% to 50% of the volume in the stock market in that period. This period also highlighted other "Macro" funds that were playing in this trade, when their losses came to light. George Soros and LTCM, for example.

http://money.cnn.com/1998/10/27/companies/soros/

Given that there were many other large "Macro" funds also investing in this period, I am standing by my opinion that the asset rally in the US from 1994 onwards was fueled by the Yen Carry Trade, and not by anything else Mr. Greenspan or the President might have attributed it to, such as a "New Economy".

And all economists that proclaimed that "the state of macro is good" or that "the central problem of depression-prevention has been solved" were dead wrong, as were their critics; in fact, Macro Economics had failed, and the problem was really simpler than one can imagine.

Yen Carry and the Stock Market

From the graph below, as well as the Samurai bond graph above, it is clear to see that, post 1994, as the Yen weakened, along with Samurai Bond issuance, the SPX rallied. Even when the Yen was strengthening after the Russian Crisis, due to and Increase in Fed Funds rate, as well as QE in Japan (captured by the Yen Carry Indicator), Samurai Bond Issuance picked up, making SPX rally again in 1999.

1999 to the Present: The Yen and Dollar Carry Trades

Starting in 1999, BOJ's Call rate was close to Zero, starting a decade of "ZIRP". The BOJ also started deploying QE, adding more potential capital that could be exported. In addition, "Mrs. Watanable", the legendary Japanese housewife, also started trading Yen for other currencies, notably Aussie$ and US$, for yet more Carry Trades.

Between Yen borrowing by banks, Samurai Bonds, Japanese QE, and Mrs. Watanabe, the Yen Carry Trade continued to fund the world. As Japanese money supply increased, along with Japanese M3, it searched far and wide for investments that would earn more than Japanese Assets. Thus began the phase that led to the Global Financial Crisis - after the supply of rational investments was exhausted, assets were being created (notably Subprime and CDOs) to feed the voracious appetites of Carry Traders.

In addition, the US Carry trade started in earnest after 9/11/2001, as the Fed cut rates from 2001 to 2004. During this period, it possibly dominated the Yen Carry Trade, reducing the Yen's correlations to US assets and stocks. When the Fed raised rates again in 2004, the Yen once again became the dominant supplier of capital to the US.

The Yen Carry Trade continued unabated until US Asset prices started collapsing in 2007.

In 2008, the Fed also started using QE, in addition to cutting rates again in 2007, once again triggering Dollar Carry, much of it to the Emerging Markets. (see CN)

The Yen Carry Trade Indicator (YCI) will be a less effective measure for this period due to the additional sources of Carry, from both Japan and the US, and marginally the ECB. Since Japan has been in ZIRP for a long time, the YCI resembles the Fed Funds Rate. After 2009, when the US cut rates to Zero too, the YCI also went to zero.

There was some Samurai bond issuance after the YCI went to zero. This was primarily from financial institutions that had been bailed out. US markets and investors were still in shock, or wanted to export capital to EM, whereas it appears that Japanese investors were still willing lend to US financials, who borrowed money where they could. (For more details, see the Samurai Bond Note).

Quantitative Easing (QE) and Central Bank Balance Sheets

Quantitative Easing is considered an 'unconventional' monetary policy, and is used to increase money supply when conventional tools have become ineffective (i.e. rates are at zero).

Wikipedia has a good definition, so I will use it:

Quantitative easing (QE) is a monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. A central bank implements quantitative easing by buying financial asets from commercial banks and other financial institutions, thus raising the prices of those financial assets and lowering their yield, while simultaneously increasing the money supply.

When US QE was implemented, I discussed why QE cannot work, in the section called 'Bonds are not Assets' in the 2009 Crisis Note 'Excess Assets, Keynes, etc'. However, QE can increase the money supply by the amount of bonds purchased (similar to an addon wing on a car increasing downforce by the amount of it's weight). Without velocity of money, however, this is a pointless exercise, unless the goal is to enrichen banks.

All three major central banks have resorted to QE, at different points in time, after entering Liquidity Traps. The extent of QE that they have implemented can be measured by the size of their (ballooning) balance sheets. The following chart shows the magnitude of their balance sheets (in USD). Combined, they currently total $8.5T, of which approximately $7.5T is as a result of QE.

Money Supply

Central banks mostly attempt to manage money supply in order to control prices and inflation. Some central banks have other mandates, such as employment targets and currency management, but the tools used are similar.

The ECB has put up a nice chart describing the Transmission of Monetary Policy.

https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html

In a prior Crisis Note, I have summarized the Bank of England's white paper titled 'The Transmission of Monetary Policy', which gives a good picture of what central banks are attempting to achieve. Here it is again:

- Central banks derive their power from the fact that they are monopoly providers of “high powered” money (base money). THIS IS IMPORTANT TO REMEMBER.
- Central banks choose the price (rate) at which they lend high powered money to the private sector.
- This official rate is transmitted to other market rates via the banking system to varying degrees, and impacts assets prices and expectations, as well as the exchange rate.
- These changes in turn effect spending, savings, and investment behavior, which impacts the demand for goods and services.
- Monetary policy works via its influence on aggregate demand in the economy. Monetary policy thus determines the general price level, and the value of money ie the purchasing power of money. (Inflation is thus a monetary phenomenon. )
- Changes in the policy rate lead to changes in behavior of both individuals and firms, which when added up over the whole economy generate changes in aggregate spending.
- Total domestic expenditure in the economy is equal to the sum of private consumption expenditure, government consumption expenditure and investment spending. This, plus the balance of trade (net exports) is equal to GDP.
- Monetary policy changes affect output and inflation, as well as inflation expectations. - Inflation expectations influence the level of real interest rates and so determine the impact of any specific nominal interest rate. They also influence price and money wage setting, and so feed into actual inflation in subsequent periods.
- Money supply plays a role in the transmission mechanism of policy, but is not a policy instrument nor a target, as the central bank has an inflation target, and uses monetary aggregates as indicators only.
- There is a positive relationship between monetary aggregates and the general level of prices. - “Monetary growth persistently in excess of that warranted by growth in the real economy will inevitably be the reflection of an interest rate policy that is inconsistent with stable inflation. So control of inflation always ultimately implies control of the monetary growth rate. However, the relationship between the monetary aggregates and nominal GDP ..appears to be insufficiently stable (partly owing to financial innovation) for the monetary aggregates to provide a robust indicator of likely future inflation developments in the near term.”

- Shocks to spending can have their origin in the banking system, that are not directly caused by changes in interest rates
– Examples include declines in bank lending caused by losses of capital on bad loans: a credit crunch.

There are a number of measures of Money Supply, depending on the country, from 'narrow' to 'broad'.

- M1 is usually a narrow definition - coins and notes in circulation

- M2 is typically M1 plus short term bank deposits, savings and checking accounts, money market funds, etc.

- M3 is M2 plus longer term deposits.

- Some countries have even broader definitions.

With that in mind, let's look at some Money Supply Data.