The Rise of Carry: How financial markets reflect power imbalances

Many parts in “The Rise of Carry” are fascinating. Lee et al. delineate the ramifications of carry in all angles of financial markets and identify the root cause for the emergence of the carry regime in a global disbalance of power and wealth. Their analysis is sometimes sharp yet often disconnected. The conclusions they draw, however, display a misconception of money and the role of policy.

Carry, as they define it, is not limited to currency carry trades. However, explaining this commonly known strategy helps derive the characteristics for carry trades. In a currency carry trade, money is borrowed in a low interest rate currency (e.g. JPY) and invested in assets in a high yielding currency region (e.g. Turkish government bonds). The player gains from this arbitrage as long as the funding leg currency does not appreciate too much.

Standard economic theory predicts the yield spread to narrow as this arbitrage is exploited by more and more actors. As sellers to carry traders (e.g. Turkish government or Turkish banks who sell government bonds) see their cash holdings increase and spend the profits, inflation is expected to kick in, thus depreciating the Lira. In reality, however, the yield spread often broadens for a while, thus attracting ever more agents to the carry bubble. Finally, the depreciating pressure kicks in. What follows is a carry crash which turns out to be especially severe as carry traders are leveraged. They cannot get enough Yen funding as their Turkish treasuries suddenly lose value.

All carry trades thus
1. are levered,
2. gain when volatility is low (“when nothing happens”),
3. provide liquidity (in the currency carry trade: liquidity to high yielding currency regions) and
4. show a skewed return structure of steady, low returns, interrupted by sudden sharp losses.

It is not required that players have understanding of their actions in order to engage in carry. Also, one may be engaged in interconnected carry trades. Consider Swiss residents from Eastern Europe as an example for both these aspects: They typically borrow from Swiss Banks and buy property to rent in Eastern Europe, where yields are high. Both buy-to-rent as well as CHF borrowing for volatile-currency investing fulfill the characteristics of a carry trade. As such, those residents are double carry traders – usually unknowingly.

Problems emerge not from carry per se, but from the increasing dominance of carry-like investment strategies across all asset markets. Their dominance, in turn, is enabled by central bank bailouts during carry crashes. Central bank intervention, beginning with the LTCM-bailout in ’98, have been limiting carry trader’s losses and thus encouraging further carry. This necessitates ever bigger central bank interventions. A vicious circle emerges.

Lee et al. rightly point to the moral hazard problem – both at the individual level (as investment managers are typically rewarded with a fixed income plus a bonus in good years, which is attractive as carry offers more good than bad years) and the macro level (while the FSB only timidly acknowledges the problem of a mis-pricing of risk through volatility suppression). What they show, in effect, is that ever higher central bank money supply (in a crash) and rising “moneyness” of private money equivalents (such as repo and money funds in good times) lead to a bloated money pyramid.

Money pyramid over time in a carry regime. After a bust, instead of reverting back to the state depicted in the left angle, central bank interventions alleviate wealth destruction and prevent deleveraging. Thus, as illustrated on the right, a new, even larger bubble emerges. Source: own illustration based on Mehrling (2016): Economics of Money and Banking (coursera Lecture)

Those private money equivalents indeed only fulfill their purpose in so far as central banks treat them as contingent liabilities. Central banks seem powerful as they keep economies afloat even during a global pandemic. However, as long as their mandates center around stability, they have little choice but to intervene when the economy is about to collapse. The increasing leverage and indebtedness, enabled by central bank backstops, lead to:
1. a steady (possibly increasing) premium for volatility insurance and liquidity provision,
2. deflationary pressure,
3. severe mis-allocation to the detriment of investment and
4. an increasing disbalance of power.

Let me explain each these four corollaries.

1.: Carry trades gain when volatility is low. This makes volatility insurance strategies profitable. Delta hedged options selling, for instance, receives implied volatility (= the premium for the option sold), and pays realized volatility (since delta hedging the underlying is more costly when the underlying turns out to be volatile around the strike price). Delta hedging, thus, is profitable when implied vola exceeds realized – which is usually the case. To hedge the risk of short term volatility spikes (volatility variance is higher around spot), those agents often trade with “short gamma” traders, which sell daily for monthly implied volatility. This strategy, in turn, profits from mean-reversion. Both strategies are carry trades, while one provides optionality, the latter liquidity, both of which have a steady positive price in a carry regime.

Structure of Volatility for the S&P 500. Source: Lee et al., p. 157

2. As the carry regime unfolds, ever higher leverage is applied by all sorts of hedge funds, dealers, mortgage buyers, wealth funds and non-financial firms. Leverage implies a demand for liquidity: different carry trades unwind over time and require players to secure additional funding (in margin calls) or to liquidate positions (in fire sales). Also, indebtedness and little growth reduce bank credit. These deflationary pressures are mitigated by private money expansion in good times. However, repo and MMF assets are liquidated during severe carry crashes as long as central banks (above all, the Fed) do not offer their high-powered money in exchange for these private equivalents. De-risking private monies, then, renders investments in levered trades comparably more profitable. Big money is largely “locked away” from the real economy (= investments and consumption), preventing inflation to occur and expanding the carry bubble.

3. Even non-financial firms are heavily engaged in carry trading. Stock-buy-backs have surged as they provide a neat opportunity to boost stock prices (thus CEO compensations). At least in the short term. If they are financed by credit, they amount to levered stock investments. Not only is it giddy for firms to risk margin calls as they bear responsibility for the workforce. Also, it implies severe mis-allocation if financial engineering is more profitable than investments. Short-term, increasing stock prices and capital gains boost GDP. Yet, the lack of investment leads to a medium term GDP gap compared to a state in which financial engineering would be less profitable. While stock-buy-backs are the obvious and timely example, excessive carry amounts to the same. Consider, for instance, the enormous wealth in Western Europe, sitting in pension, fixed-income and wealth funds while funding for start-ups comes from US and Chinese venture capital.

4. Carry trades are a privilege for those with access to expertise and leverage. Liquidity provision is by definition reserved for the affluent. As carry traders are backstopped by central banks, public (monetary) authorities are held hostage by the carry regime. The fundamental instability of fiat money (being backed by no real asset) enables governments’ monopoly on liquidity provision and gives them the power to choose whom to help and whom to bill.

The authors then depict the carry regime as the result of power and wealth. However, in drawing the direct causal linkage, they overlook that, absent political pressure from the bottom, all institutions are shaped in order to favor the powerful. After all, it is the definition of power to change the way things work in one’s favor. Liquidity provision by the rich is so mundane and omnipresent in the history of civilization and a service hardly suspicious. Banking, after all, is fundamentally about transferring funds from saturated to the needy with high potential to deliver profits. Looking closely, banking fulfills all four characteristics of carry trading which just shows how broad a phenomenon the authors seek to analyze.

Shadow banking maturity transformation and leverage. Source: Pozsar (2014): Shadow Banking: The Money View

A certain amount of carry, viz. liquidity provision and arbitraging, is necessary. The problem lies in the dominance of carry, the levels of leverage and indebtedness. But these levels can be brought down. HNWIs can be taxed, central bank interventions can be reduced in bad, or – maybe more realistically – reverted quickly in good times. The public can demand more democratic power over monetary institutions. Also, societal changes may close the knowledge gap between carry trading institutions and retail investors. A good example are retail option buyers exploiting the requirement for call sellers to trade with the market to stay delta-neutral. As retail investors gather at social media to buy calls, they benefit from a self-fulfilling prophecy, while large call sellers suffer from realized volatility being higher than implied.

To expect the financial system to do anything but to reflect the imbalances in society is wishful thinking. It is the domain of politics to alleviate imbalances. Also, instability is a fundamental feature in all monetary regimes, albeit more pronounced in fiat systems. Monetary authorities have always had to find a balance between flexibility and discipline. The two solutions to the problem of fiat money outlined by Lee et al. both ignore the necessity for flexibility: The first solution, increasing cost of production (such as Bitcoin’s consensus algorithm), reduces the possibility to backstop carry trading. Similar to the Dollar during Bretton Woods, such a system would likely fail to meet money demand during growth periods and lead to deflation. The merits and problems of a deflationary Bitcoin standard is a fascinating topic – but too much for the current discussion and certainly not to be expected within the next several years. The second solution presented is to link money to the economy’s real asset base. Tokenization could enable a basket of national assets (stocks, bonds, real estate) to function as currency. Yet, it is not clear how a downward spiral could be prevented when these assets temporarily lose value.

As a consequence, it is not at all obvious that

the absolute end of the carry regime is likely to be marked by either systemic collapse that ends the dominant role of central banks or galloping inflation – or both. If a crash results in neither of these two things happening, then the likelihood is that the carry regime continues and there will be a new carry bubble.

Lee et al., p. 210

More likely than revolutionary overturns or inflationary chaos seems to me a diminishing return on many carry strategies as markets are crowded by those in search for yield. Negative yields on fixed-income and money fund shares might further encourage flows to exotic (= emerging market or Bitcoin), young (= start-up) and small (= SME) investments. Securitization, via Loan Warehousing, might enable the reallocation to companies most in need. Eroding trust in governments’ abilities to service debt might encourage investments into more productive areas than Treasuries. Especially Bitcoin might develop a suction to direct ever more flows away from levered finance. With decreasing seigniorage, the American monetary authorities may lose their power to back the bonanza, which would equate to a slow death of the carry regime.

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