PDF Summary:The Rise of Carry, by Tim Lee, Jamie Lee, and Kevin Coldiron

The Rise of Carry, by Tim Lee, Jamie Lee, and Kevin Coldiron, examines the world of carry trades—financial strategies that leverage interest rate differences by borrowing in low-yield currencies to invest in higher-yield assets. These trades flourish in stable markets but can result in severe losses during volatility.

The authors explore how carry trades have evolved from foreign exchange dealings to permeate global markets, enabled by central bank policies and financial engineering. They argue that this "carry regime" fuels economic distortions, exacerbates wealth inequality, and poses systemic risks to the financial system itself as speculative capital flows reshape modern economies.

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Hedge funds' reliance on considerable borrowing greatly increases their susceptibility to the inherent dangers linked to activities involving carry trades.

The authors also stress in this chapter that virtually all hedge funds employ leverage and that this further encourages them to be carry traders - even for those funds that have strong enough balance sheets to take the risks of short volatility strategies because the mechanics of managing leverage bias a portfolio toward carry. Therefore, the increase in the assets hedge funds manage, by 25 times over the past twenty years or so - which in turn implies that the aggregate influence of hedge funds on global markets has grown by an even greater magnitude than this - has been very important in producing the growth of the carry regime.

Sovereign wealth funds, with their substantial fiscal capacity and orientation towards enduring investments, are ideally positioned to execute carry strategies.

Sovereign wealth funds now oversee assets that have swelled to an impressive total of approximately 7.5 trillion US dollars. Are they generally in favor of the concept of carry? Sovereign wealth funds are inherently structured to perform these financial operations effectively. Sovereign wealth funds, though they can take many forms, typically share the characteristic of managing pools of capital with very long durations: in many cases the capital itself is effectively considered to be permanent capital. These organizations are designed to provide a steady source of market liquidity and have the ability to offer loans, given that their financial commitments are stable and not subject to abrupt cancellations.

Sovereign wealth funds have a liability structure that allows them to handle the risks linked to carry trade operations.

Sovereign wealth funds are generally responsible for administering the surplus financial assets of nations or their governments. Norway has amassed approximately $1 trillion from its oil revenues, and this national wealth is managed by a sovereign wealth fund tasked with its oversight. The liabilities corresponding to those assets are categorized as “owner’s capital” in the fund’s reports, which is long-duration equity. The fund does not have to produce yearly gains and is not bound to reveal its performance data in the way that is customary for hedge funds. It is therefore not subject to the same incentives that lead hedge funds to pursue carry. It has the necessary financial robustness to engage in long-term investment strategies that leverage debt. Engaging in carry trading can be beneficial because it has the resilience to endure temporary downturns and can amplify gains, thereby bolstering long-term outcomes.

Government-operated investment funds can potentially increase their earnings derived from carry through the utilization of leveraged capital.

Carry trades often utilize borrowed capital to amplify returns that would typically be modest without such financial tactics. Sovereign investment funds, known for their strong fiscal stability and ability to handle long-term obligations, are especially suited to execute carry strategies, largely because they make prudent use of borrowed capital when it's needed. The authors suggest that these entities could serve as natural stabilizers within the market, providing a more reliable refuge for carry trades than hedge funds, due to their strong financial standing.

The assessment of market volatility is a key factor in determining the current carry regime, especially in the context of the S&P 500 markets.

The authors examine the various facets of the American stock market. The authors clarify how the S&P 500 is a crucial factor in the global context of carry trade activities. Regularly adjusting a leveraged position by acquiring more assets as prices increase and divesting as they decrease incurs continuous costs associated with the fluctuations of the S&P 500; conversely, adopting a contrarian approach by selling during market upswings and purchasing during downturns can frequently lead to consistent profits. But this profitability can only exist because in a world with so much leverage, someone has to be willing to provide the necessary liquidity - which means selling volatility. The S&P 500 seems to have evolved into a strategy that exploits differences in interest rates.

Entities are compensated for providing both liquidity and leverage.

Selling options or establishing short positions in futures tied to the VIX is tantamount to profiting from market declines. Traders or speculators who sell volatility essentially take on a stance that, although it produces revenue, exposes them to the potential for unlimited losses. Market participants supplying liquidity to the S&P 500 are in a position where maintaining their leverage depends on the continuous availability of liquid assets, which allows them to demand a significant premium. The significant premium associated with the S&P 500 makes it an effective instrument for carry trading activities.

global volatility pricing and carry strategies is now predominantly influenced by the S&P 500 index.

The authors recognize that a variety of global stock market indices share traits similar to the S&P 500. The S&P 500 is a crucial player in the global leverage market, necessitating liquidity, and has become the primary carry trade due to its status as the equity index that is the most significant, most liquid, and most closely watched.

Other Perspectives

• The role of financial institutions in the valuation of volatility and expansion of the Carry Trade may not always be critical; market forces and macroeconomic factors can also play significant roles.
• Sovereign wealth funds, while influential, may not always prioritize carry trade strategies over other investment opportunities that align with their risk and return profiles.
• Hedge funds' compensation models and use of leveraged funds might not always lead to facilitating carry trades; some funds may focus on other strategies that do not involve leverage or carry trade tactics.
• The assertion that hedge funds employ tactics similar to carry trades to produce consistent profits overlooks the diversity of strategies employed by different funds, some of which may prioritize high-risk, high-reward trades over consistent, modest gains.
• The susceptibility of hedge funds to risks associated with carry trades due to reliance on borrowing may be mitigated by sophisticated risk management techniques and diversification strategies that hedge funds employ.
• Sovereign wealth funds' ideal positioning for carry strategies assumes a uniformity in their investment approaches, which may not account for the varying mandates and investment objectives of these funds.
• The liability structure of sovereign wealth funds may not always allow them to handle the risks linked to carry trade operations, especially in times of global financial stress or when national priorities shift.
• Government-operated investment funds may face political and ethical considerations that limit their ability to engage in leveraged carry trades, which could be seen as speculative and not aligned with their mandate.
• The assessment of market volatility, particularly with the S&P 500, may not be the only or the most crucial factor in determining the carry regime, as other factors like geopolitical events, monetary policies, and economic indicators can also have significant impacts.
• The compensation for providing liquidity and leverage in the market may not always be significant or justified, as it can sometimes lead to systemic risks and market distortions.
• The influence of the S&P 500 on global volatility pricing and carry strategies, while significant, may not be as dominant as suggested, considering the impact of other global indices and asset classes.

The way the carry regime shapes central bank policies, plays a role in the formation of economic bubbles, and impacts macroeconomic outcomes.

The concluding part of the discussion delves into the manner in which the prevailing global carry regime has become a defining force in the contemporary business cycle, ultimately leading to a situation where both economic expansion and interest rates are trending towards a null point. The prevailing perspective, which once considered the manipulation of interest rates to be the primary force behind the growth of credit and the oscillations in the business cycle, is now regarded as outdated. Carry trades, which often grow due to the actions of central banks, generally lead to considerable early gains but also pave the way for the formation of large market bubbles and their subsequent collapse.

The carry regime often results in a downward pressure on prices, which in turn causes a reduction in interest rates, an increase in borrowing, and a deceleration of economic growth.

The writers argue that worldwide economies and financial markets are now primarily driven and significantly influenced by the concept of carry. The writers argue that the prevalent engagement in carry trades encourages deflation by fostering too much debt and mispricing risk, thereby obstructing authentic economic growth. The expected increase in carry trades is predicted to result in the formation of credit bubbles that, upon bursting, will exacerbate deflationary pressures. The complexity inherent in the dynamics naturally becomes more intense.

The carry regime leads to a notably inefficient distribution of economic resources and capital.

The carry regime's impact plays a significant role in molding economic progress through its sway over investment and financing decisions in the system. The proliferation of carry trading might lead to a general belief that the cost of borrowing and associated risks are underestimated, thereby prolonging the existence of unsustainable investments beyond their deserved duration and distorting choices pertaining to consumption and investments. Consider a situation where a surge in buyers drawn to the idea of purchasing properties as investments causes a real estate bubble to inflate, and this expansion is further driven by financing from participants in carry trades, encompassing various private and institutional investors. An inflated valuation of the real estate sector can result in the excessive building of residential units, surpassing genuine demand because of a miscalculated evaluation of risk, which leads to a considerable waste of resources when property values ultimately decline. The collapse of the carry bubble triggers a rapid and severe reversal of all characteristics linked to the accumulation of leveraged debt and the formerly heightened sense of liquidity and value.

The temporary surge in Gross Domestic Product, fueled by debt-supported spending and investment, masks the underlying erosion of essential economic growth.

The authors clarify their argument by explaining how a significant increase in oil production in the United States led to a marked decrease in oil prices starting in 2014. The authors argue that high oil prices were supported by a speculative carry trade, which in turn encouraged US shale producers to take on debt and accelerate production. The increase in production, bolstered by capital influx from carry trade activities, temporarily boosted the US GDP by keeping oil prices elevated. The bubble's endurance was never anything but a mirage. Countries that once experienced a boost from engaging in carry trades could encounter substantial deflationary effects if there is a shift in commodity prices. The precipitous drop in the cost of oil led to the insolvency of many shale companies with unstable financial foundations, causing their lenders to suffer substantial losses. The decline of the petroleum sector beginning in 2014 had a negative impact on the US economy, but it also resulted in a more precise evaluation of economic circumstances, which in turn facilitated the adjustment of oil production to meet true market demand.

The establishment of the carry regime is partly attributable to the substantial impact of central bank policies that have diminished market fluctuations and provided implicit guarantees.

Central banks are instrumental in promoting the growth of carry trades. The environment for carry trades and similar strategies has been significantly encouraged by a mix of persistently low-cost borrowing opportunities, which have been facilitated by the consistent actions of central banks in many major economies, alongside their commitments, whether inferred or occasionally stated outright, to uphold financial markets during times of turbulence, as well as rescuing markets and institutions that suffer the most when carry trades falter.

The inclination of central banks to intervene in market fluctuations, along with their permissive stance on monetary policy, has made carry trading activities more attractive.

Kevin Coldiron highlights the detrimental cycle where central banks continuously fuel carry bubbles, ultimately resulting in volatile market crashes. Central bank strategies such as quantitative easing, intended to bolster economic expansion and stabilize the financial system, actually intensify the inherent deflationary bias within the carry regime. Central banks are confronted with a challenging situation where their efforts to expand the money supply and mitigate market volatility after a carry crash, such as the one experienced during the global financial crisis, unintentionally make carry trading more attractive by softening the blow of losses, thereby encouraging the formation of an even bigger carry bubble in the future.

The central bank's balance sheet has undergone significant expansion, reflecting a considerable carry trade that, in turn, bolsters the existing financial architecture.

The publication emphasizes the pivotal role that central banks play in engaging with carry trade activities. After all, what is QE if not a strategy where the central bank engages in low-cost short-term borrowing to fund the acquisition of longer-term assets with higher returns, which encompasses the purchase of assets such as sovereign debt, securities backed by mortgages, and debt issued by corporations? This signifies a substantial carry trade. Is it surprising that an increased number of participants have benefited from participating in carry trades within the Carry Regime?

Economic downturns are now frequently precipitated by a consistent pattern of bubbles in carry trade and their subsequent collapses, which have become intertwined with the business cycle.

The authors argue that the importance of the conventional business cycle has waned relative to the more dominant sequence of carry regime fluctuations, which are marked by the emergence and bursting of financial bubbles.

A collapse in carry trades can lead to a rapid evaporation of market liquidity, which in turn can cause the economy to contract.

The carry regime's influence, which reduces fluctuations in the market, broadens the understanding of what constitutes currency, and fosters the view of financial assets as an alternative to traditional money, masks the underlying economic imbalances that often herald an approaching recession. The rhythm of the economic cycle is now increasingly influenced by the regularity of "carry" crashes, which mold the contours of the financial and economic landscapes.

Central banks' actions to amplify carry trades by injecting liquidity persist in driving the trend towards greater market fluctuations and declines.

Carry trades might create a deceptive appearance of a thriving economy, but in reality, they only prompt a slight uptick in economic activity while the overall rate of economic expansion slows down. The expansion is mainly ascribed to the idea of financial leverage instead of genuine economic endeavors that require the sacrifice of present consumption for the sake of investment. The broad accessibility of credit often boosts manufacturing and employment, leading to a rise in income as a consequence. Extended periods of profitability can create a misleading perception. The bursting of the carry trade bubble precipitates a swift reversal of those investments, causing a sudden decrease in spending that results in a substantial deflationary effect, a phenomenon frequently overlooked by conventional financial metrics.

Context

• Carry trades involve borrowing money in a currency with low interest rates to invest in assets denominated in a currency with higher interest rates, profiting from the interest rate differential. The carry regime encompasses the environment and conditions that influence the prevalence and outcomes of carry trades in financial markets. Central banks' policies and market dynamics play a significant role in shaping the carry regime and impacting the behavior of carry trades. Carry trades can lead to market bubbles and economic imbalances due to the potential for excessive risk-taking and misallocation of capital.
• Carry trades can lead to deflationary effects by encouraging excessive debt and mispricing risk, hindering genuine economic growth. When carry trades inflate asset bubbles that eventually burst, it can result in a rapid reversal of investments, leading to decreased spending and a deflationary impact on the economy. This deflationary effect occurs as the unwinding of leveraged positions and the sudden loss of liquidity can cause a significant downturn in economic activity. The deflationary consequences of carry trades highlight the risks associated with unsustainable investments fueled by excessive borrowing and distorted risk perceptions.
• Carry trades involve borrowing in a low-interest-rate currency to invest in a higher-yielding asset. When carry trades become popular, they can lead to excessive risk-taking and asset price inflation, potentially creating economic bubbles. The unwinding of these carry trades during market corrections or shifts in economic conditions can trigger the collapse of these bubbles, leading to significant market disruptions and economic downturns. Central bank policies can influence the prevalence and impact of carry trades, as their actions can affect interest rates and market conditions, further shaping the dynamics of economic bubbles.
• Central bank policies influence carry trades by providing low-cost borrowing opportunities and implicit guarantees, encouraging investors to engage in these trades. Actions like quantitative easing by central banks can inadvertently make carry trading more attractive by softening losses, potentially leading to the formation of larger carry bubbles. Central banks' interventions in market fluctuations and permissive monetary policies contribute to the attractiveness of carry trading activities. The expansion of central bank balance sheets through strategies like quantitative easing reflects significant engagement in carry trade activities.
• Market liquidity represents how easily assets can be bought or sold in the market without significantly impacting their prices. When there is a collapse in carry trades, it can lead to a rapid evaporation of market liquidity. This means that assets become harder to buy or sell quickly, leading to a lack of trading activity and potentially causing the economy to contract. The evaporation of market liquidity can exacerbate market volatility and make it challenging for investors to execute trades efficiently.
• Central banks influence market fluctuations through their monetary policies, such as setting interest rates and implementing quantitative easing. By adjusting these policies, central banks can impact borrowing costs, liquidity levels, and overall market stability. Central banks' interventions can either dampen or exacerbate market fluctuations, depending on the economic conditions they are trying to address. Their actions are aimed at maintaining financial stability, supporting economic growth, and managing inflation levels within an economy.
• Carry trade collapses can lead to economic downturns due to the rapid evaporation of market liquidity, causing a contraction in the economy. The unwinding of carry trades can trigger a chain reaction, impacting asset prices and financial stability. This can result in reduced investment, lower consumer spending, and overall economic slowdown. Central banks' actions in amplifying carry trades can exacerbate market fluctuations, contributing to the cycle of carry trade collapses and economic downturns.

The broader implications of the carry trade dynamic extend to matters of wealth disparity, shifts in power dynamics, and embedded dangers.

The authors explore the broader consequences of the carry regime, recognizing that its influence goes beyond a simple financial concept and encapsulates the power dynamics present in social exchanges. The authors argue that the carry regime's intrinsic instability exacerbates economic stagnation and amplifies the growing disparity in the distribution of wealth. Central banks have unintentionally trapped themselves by their own actions of intervention.

The regime of carry intensifies the accumulation of wealth and power among capital providers and individuals who facilitate the smooth operation of markets.

The authors emphasize that the current carry system exacerbates imbalances and consolidates power within organizations that provide crucial liquidity or leverage to the economy and financial markets.

Engaging in carry trades can amplify situations where small initial advantages may balloon into substantial imbalances.

Chapter 11 characterizes carry as a mechanism that inadvertently redistributes wealth from those burdened with debt or seeking liquidity towards organizations with the fiscal robustness and excess capital to be selective in their investment choices. As progress occurs, the initial slight differences in resources and influence often escalate quickly, leading to a significantly unequal distribution of wealth and income.

The carry regime reconfigures the financial system to focus on generating profits through reduced volatility rather than emphasizing the productive distribution of capital.

Wealth accumulation in the financial sector is now significantly influenced by the profits generated from carry trading operations. The enticement of participating in carry trades and strategies characterized by selling volatility undermines authentic investment that supports substantial economic expansion, with advantages that gradually accumulate for the wider population. The economic and financial systems naturally incline towards certain sectors that derive greater benefits within the carry regime.

Certain individuals accumulate wealth through their impact on fiscal and oversight measures.

As this perspective is considered, the carry regime increasingly resembles a parasitic entity, seeking to extract rent or benefit, with its influence intensifying as time progresses.

Central bank activities have unintentionally strengthened the carry regime, leading to an intensified concentration of power and wealth.

Central banks have the power to create money, an action they undertake to maintain economic price stability. The financial system is structured to consolidate power within the hands of a select group. Financial institutions engaged in activities that appear to be high-risk are supported by the foundational role of central banks. Consequently, those who persevere through the declines in carry trades typically find themselves holding a greater share of wealth during subsequent expansions of these trades, a circumstance that is in part enabled by the measures taken by monetary authorities.

The inherent instability of the carry trade approach presents systemic risks to broader economic and financial structures.

The authors suggest that the end of the carry regime might herald the end of the existing fiat currency system and the dominant role of central banks. The existing framework's transformation leaves the future uncertain. Understanding the dangers associated with extended involvement in carry trade activities is crucial for initiating reforms that lead to a sustainable system and a more equitable future.

Context

• The carry trade dynamic involves borrowing money in a currency with low interest rates to invest in a currency with higher interest rates, profiting from the interest rate differential. This strategy can lead to increased market volatility and risks due to fluctuations in exchange rates. It can impact wealth distribution, power dynamics, and economic stability on a broader scale. Central banks' interventions and market participants' actions play significant roles in shaping the outcomes of carry trades.
• "Fiscal robustness" typically refers to the financial strength and stability of an entity, such as a company or an economy. It indicates the ability to withstand economic challenges, manage risks effectively, and maintain a healthy financial position. Entities with fiscal robustness are better equipped to navigate uncertainties and shocks in the financial system. This term is often used to describe the resilience and soundness of financial structures or institutions.
• Selling volatility, in the context of financial markets, involves strategies where traders profit from a decrease in price fluctuations. This can be done by selling options or engaging in trades that benefit from a decrease in market volatility. Traders who sell volatility are essentially betting that the market will remain stable or that price movements will be limited. This strategy can be used to generate income in periods of low market volatility.
• A fiat currency system is a monetary system where the currency's value is not backed by a physical commodity like gold or silver. Instead, the value is derived from the government's declaration and people's trust in the currency. Central banks typically manage fiat currencies, controlling the money supply and interest rates to stabilize the economy. This system allows for flexibility in adjusting the money supply to meet economic needs but can be susceptible to inflation if not managed carefully.
• Central bank activities can inadvertently strengthen the carry regime by providing support to financial institutions engaged in high-risk activities, such as carry trades. This support can create an environment where these institutions are encouraged to take on more risk, leading to an intensified concentration of power and wealth within the financial system. Central banks play a foundational role in maintaining economic stability, but their actions can also inadvertently contribute to the amplification of imbalances and risks associated with the carry trade approach.
• The carry trade approach involves borrowing money in a low-interest-rate currency to invest in a higher-yielding asset, aiming to profit from the interest rate differential. However, this strategy can lead to significant risks due to currency fluctuations, market volatility, and sudden shifts in investor sentiment. The inherent instability of carry trades can amplify market imbalances, potentially causing disruptions to broader economic and financial systems. These risks can be exacerbated during periods of economic uncertainty or when there is a sudden reversal in market conditions.