One great book I’ve been reading lately is The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee, and Kevin Coldiron (Amazon affiliate link)
This book has been eye-opening to me. The authors have elegantly connected the dots between Central bank interventions, interest rates, the carry trade, bringing all of these elements together.
The concepts explained in this book made me understand why fundamental analysis seems to matter less these days and why Federal Reserve press conferences garner so much attention.
What is the carry trade?
A carry trade is a type of trade that makes money when “nothing happens” or when volatility is low (variance of price is low). This trade is similar to selling insurance, where you collect a premium in exchange for taking on downside risk of some event taking place.
A carry trade can be done in a number of ways. The term “carry trade” is a broad term that groups these different types of trades together.
What are the features of a carry trade?
The features of the carry trade include leverage, liquidity provision, short exposure to volatility, and a “sawtooth” return pattern of small steady profits punctuated by occasional large losses.
What is an example of carry trade?
One type of carry trade is a currency carry trade. In this trade, you borrow a currency that has a low interest rate, then use that money to buy another currency that pays a higher interest rate.
The goal of this trade is to profit on the difference between the interest rates.
However, one problem with this trade is that on its own, it doesn’t have high yields. The payoff for this trade is small, so to increase returns and make these investments more attractive for investors, those who do these trades employ significant leverage. Leverage on such trades could be 10 to 1, 20 to 1, sometimes even 60 to 1 leverage.
Why are carry trades popular with investors?
Carry trades generally will return steady profits for extended periods of time. This is what makes them attractive to investors. During boring times in the market with low volatility, these strategies are profitable.
What are the drawbacks to the carry trade?
When the carry trade loses money, it has the potential to lose a lot in a hurry. This massive loss potential is due to the amount of leverage used in a carry trade. Because the carry trade relies on stability in prices (low volatility), any behavior outside of “normal” behavior leads to high volatility and high losses.
In addition, carry trades have an effect of increasing liquidity as the carry trade expansion phase goes on. This leads to a carry bubble. As the carry bubble pops, the carry trade has the opposite affect on liquidity. The decrease in liquidity in the market happens because carry trades are forced to be reduced or closed altogether.
In this sense, the cycle of the carry bubble and carry crash and the economic cycle have become one in the same.
To be continued…
Good articles for more information
As I watched a 2,000-point sell-off in the Dow Jones Industrial Average on Thursday, March 12, I realized that Tim Lee — the founder and chief economist at piEconomics — had got it all figured out before he recently retired.
Along with co-authors Jamie Lee (no relation) and Kevin Coldiron in The Rise of Carry, he laid out his theory of how unprecedented levels — and types of — central bank intervention in financial markets over the past few decades have turned the global economy into a series of overlapping carry trades…
This article and series of articles continues to be a work-in-progress.