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The Unwinding of the Carry TradeJohn Mauldin
Will rising rates cause the hedge fund world to blow up and bring down the economies of the world? What about the huge recent rise in the money supply? Are the large employment numbers for real? Is inflation coming back? Will the economy continue to grow? All good questions upon which we will muse. (Yes, I know I was supposed to write about the housing bubble, but my associates keep bringing in important new research which must be read. Unfortunately, they are all quite long and written by PhD economists, which is to say, dense and complex. I will get to it, I promise). The Unwinding of the Carry Trade First, a few thoughts about the risk to world markets caused by highly leveraged hedge funds as interest rates rise. Hedge funds have been some of the prime beneficiaries and users of the carry trade (borrowing at ultra low short terms rates and investing in longer term instruments with higher rates to make the difference in the coupons). Knowing that the Fed was committed to keeping rates low for a "considerable period" of time, hedge funds, major banking houses, active managers and corporations borrowed at very low rates to invest in all manner of investments: longer term bonds, foreign bonds and currencies, commodities, all manner of derivative debt, etc. Corporations swapped out long-term debt for short term debt. Let us be sure that the carry trade in the world was huge as of the middle of March, 2004. Further, the markets only thought that the Fed would raise rates by 50 basis points by the end of the year in mid-March. Count me in that group, as I did not think the Fed would raise rates until after the election. Hedge funds and the groups mentioned above, although their hands were on the trigger, were enjoying the nice spread. Life had been very good for some time and Sir Alan was their best friend. Except that Alan and crew started giving speeches warning about inflation and hinting at the end of low rates. As I wrote then it was a blatant move to get hedge funds to begin to unwind their carry trades. It worked. Then employment started to pick up. Economic numbers continued to look good and a whiff of inflation began to actually appear on the world scene. The facts changed, and the very real suspicion that the Fed would start tightening in June became the theme throughout the investment world. Now, the markets are pricing in interest rate hikes to begin in June and a full 175 basis points by the end of the year. Fed members are still using words like "measured" and "patient" when they talk about hikes, but they are clearly letting people know they are ready to begin the rate raising cycle. Today's employment numbers (more later) were quite good. It has been my contention that the Fed would not raise rates until either strong inflation or solid employment numbers (or both) were evident. Now they are. There are a number of questions we need to think about. Why is the Fed likely to go slowly, raising only 25 basis points at a time? How high will rates ultimately rise? Will such a stimulating go-slow policy, if pursued, result in rising inflation? Nearly everyone agrees that the "natural" rate for Fed funds should be between 3 and 4 percent. Anything less is still stimulating the economy. Such an environment encourages more inflation and is boosting the economy. Normally, when the economy is growing as well as it is now and inflation starts to come back, the Fed starts to tap on the brake pedal to slow things down. A rate of 1.5% or 2% or even 3% in an economy growing 4% with well over 2% inflation cannot be called putting on the brakes. 25 basis point rate increases are very gentle tapping indeed. Why would the Fed risk a return of inflation? A number of bearish observers have written that they expect a financial crisis, if not a meltdown, to result from hedge funds and investment banks all procrastinating and then trying to exit their carry trades at the same time at the last minute. And indeed, if that were the case, we could (probably would) see a crisis. But that is not what is happening. April was not a good month for most funds involved in the carry trade. For some, it was ugly. The month of May has been better, but only by degree. The early numbers suggest that May will again be a losing month for those funds. My conclusion/observation/conjecture is that the unwinding of the carry trade is in process. The funds which have made so much over the last year on these trades are now paying the price to lock in their profits. Thus, the speculation that drove commodities and all manner of investments to overbought levels is being driven from the market. Thus, you see copper and gold dropping, interest rates rise as speculators sell their long bonds and all manner of market moves as margin clerks require funds to maintain cash levels. They do not care where the cash comes from, so funds that have less liquid derivative positions and also gold exposure may be selling gold to raise cash, as an example. (Why else would gold be dropping as inflation is rising and the money supply is exploding?) Or it could be copper or Russian stocks which get hammered by the margin clerks (could we once again be talking value and Russian stocks in the same breath?). Greenspan and Company recognize that they created the carry trade. It was a side effect of their desire to stimulate the economy with lower rates. They also recognize the dangers of those trades unwinding too fast, causing deep losses and therefore requiring margin clerks, who have neither soul nor an ounce of mercy, to force funds and traders to sell in order to meet minimum cash requirements. The carry trade is so massive that the fears is that a too quick retreat could create a cascade. Think Long Term Capital Management. Thus, Greenspan began to send clear signals in late March. By mid-April the unwinding had begun and is still going on today. Overall, it has been orderly, although some traders have not been happy, there are no major disasters surfacing and so far we do not see a lot of abnormal pressure in the markets. Greenspan (and to be realistic, so do you and I, gentle reader) wants to see this process continue to be orderly. Remember his speech of last August? The first rule of central banking is to avoid taking major risks. The small risk of a cascading implosion in the unwinding of the carry trade is nowhere near as great as a little extra inflation that can be dealt with later. Thus, I think the Fed will raise rates slowly until they perceive the dangers from this unwinding are gone. At that point, they will start to raise rates in earnest, 50 basis points at a time. But when will this be? I do not think it will be as early as August. Maybe not even this year. But then again, if the process continues apace, perhaps they can indeed raise rates faster, getting us closer to that equilibrium level. And perhaps (repeat perhaps) that explains why the money supply is rising at levels usually associated with severe problems, like 9/11 or the summer of 1998. It is just another form of insurance that the carry trade will be unwound in an orderly fashion. As liquidity is being taken off the table in one form (the carry trade) it is being added by the Fed in another. I should note that I do not see the dire predictions of some who think the recent (admittedly large) rise in the money supply herald the end of the world. In reality, we are playing "catch up" for the reversal in the growth of the money supply last year. In a year over year basis, taking into account both periods, monetary growth is not all that large for a period of economic growth like we are currently in. Inflation: The Fed Gets What It Wants One of the smartest observers of the economic world is Martin Barnes of the Bank Credit Analyst. Their forecasting has been as right on as any service I know. Central bankers and major institutions from all over the world read Martin, and well they should. Their June issue just came out, and let me quote from a special study they did on inflation entitled: "Inflation: The Fed Gets What It Wants." "There was too much market complacency about the inflation outlook in late 2003/early 2004, setting the scene for recent price data to catch investors off guard. The underlying inflation rate was never as weak last year as implied by the consumer price index and the recent acceleration partly reflects an unwinding of earlier distortions. The cyclical trend in inflation is up, albeit gradually. The Federal Reserve has been targeting higher inflation by running a hyperexpansionary monetary policy. While interest rates will be normalized over the next 12 to 18 months, policy gradualism will allow inflation to keep rising. The prices of goods and services purchased every day, week and month are rising at a steady pace. Deflation has been concentrated in durable goods, which are purchased infrequently. Moreover, trends in used car prices and owners' equivalent rent have obscured underlying inflation trends. The core inflation rate is headed to 3% or higher and the Fed will eventually have to flatten or invert the yield curve. Stay underweight bonds." www.bcaresearch.com. Martin brought up some very interesting points in this study. First, exactly how does the consumer price index (CPI) seem to understate an inflation that seems readily apparent to all? One reason is that "nearly all of the deflationary pressures during the past couple of years have been concentrated in durables goods, which account for only 11% of the overall CPI. The core annual inflation rate excluding durables never dropped much below 2% and is now up to 2. 6%." "There is even a twist within the inflation rate for durables. According to the official data, the price of used cars plunged at a 21% annualized pace between June and December of last year, exerting significant downward pressure on the durables inflation rate. The CPI for used cars has started to edge higher this year. A private-industry index of used car prices tells a different and perhaps more plausible story. The Manheim Used Vehicle Index: www.manheimvalueindex.com is based on a large sample of actual transactions and shows a marked upturn in the inflation rate for used vehicles in the past year. If the Manheim index is used instead of the CPI measure of used car prices, then the annual change in durable goods prices would have been minus 0.5% in April as opposed to the minus 3.5% shown in the published data (Chart III-2 on page 24). The 'truth' is probably somewhere in the middle." Another way in which inflation gets understated is that the rise in owner-occupied housing costs are measured by using an estimate of the rent homeowners would have to pay to live in their homes. This measure accounts for 32.9% of the core CPI. In April, core inflation for the last three months was 3.3%, which is quite the rise from 1.2% for last October. If you exclude the housing costs, core inflation for the last three months has risen 4.5%. It was 3.5% last October. Thus, using equivalent rent costs, which have not risen all that much, as a measure for all housing costs, has the very real potential to understate inflation. Martin has put his finger on the very topic I wrote about last week, and that is what I called the "end game" for the Fed. Just as they are committed to not allowing deflation, they are also not going to allow their recent legacy of controlling inflation to go by the wayside. I have maintained for some time that the Fed will allow inflation to increase more than most observers now believe. I also believe they will work to bring it back down. The trick, the end game, is whether they will be able to do so without causing a recession. Martin suggests: "...the Fed will eventually have to flatten or invert the yield curve." The Fed knows, and their own studies show (I have written about them on more than one occasion) that an inverted yield curve is a pre-cursor to a recession. I have trouble believing that the Fed will actively produce an inverted yield curve. But I can readily see the Fed being forced by the markets to take actions they loathe. The question is whether they can raise rates fast enough to keep inflation from becoming a real problem without also risking a problem in the markets from the unwinding of the carry trade. It is a delicate balancing act. I can envision a scenario where this happens, but it requires a lot of good things all happening in concert. There can be no hiccups or bumps from a lot of problem areas. The trade deficit, the US budget, consumer spending, currencies, etc. Can the housing market stay strong with mortgage rates at 8% and ARMS at 6%? It was only four years ago that ARMS were almost 7%. We tend to forget that only four years ago, short term rates were 6.5%. An eventual rise to a mere 4% is certainly likely. In 1998, when I wrote about mortgage rates going to 5%, most readers thought I was nuts. Some asked me to send them whatever I was smoking, as it was clearly good stuff. In a blatant plug for my book, Bull's Eye Investing, I would suggest that you go to chapters 5 and 6 and see what the dual combo of rising interest rates and inflation do to the stock market. It is not pretty. When the market begins to perceive real inflation and a significant rise in interest rates, you do not want to be naked long the market. Until then, maybe. And it may take a long time for that perception to actually come about. But just as the unwinding of the carry trade started quite rapidly and continued, albeit behind the scenes, the return of the bear market will be quick. Keep your hand on the trigger. The Employment Numbers: A Good Story But let's not leave on a downer note. All those problems are for next year, or maybe in 2006. Right now, the economy is rocking along and creating jobs. We saw pay rise a respectable $.05 in May, and 248,000 jobs were added. The actual rise in temporary jobs was only 2,000. Since May of last year, 1.3 million jobs have been added, the bulk of those in the last four months. Of course, you could throw some water on the wage parade and note that inflation is also up, but let's not. Ok, just one tidbit for the bears so they can feel happy. Last year, the employment numbers started to include an estimate for the birth and death of new businesses. There is a time lag between the time these businesses are created (or die) and when the Bureau of Labor Statistics finds out about them. So they have created some fairly elaborate models for estimating the numbers of new businesses. While this does attempt to show more realism in the actual final number, it also throws some subjectivity into the numbers. As they note on their site www.bls.gov, "The most significant potential drawback to this or any model-based approach is that time series modeling assumes a predictable continuation of historical patterns and relationships and therefore is likely to have some difficulty producing reliable estimates at economic turning points or during periods when there are sudden changes in trend. BLS will continue researching alternative model-based techniques for the net birth/death component; it is likely to remain as the most problematic part of the estimation process." Last month, 195,000 jobs were in that category across the entire spectrum of the employment markets. They estimate over 700,000 new businesses have been created in the last four months alone, or more than double the amount created in the preceding 10 months. Were those 195,000 real, or were they the creation of a government agency desperate to show employment growth? As they note, this model will understate growth at the beginning of recoveries and mask problems at the beginning of downturns. But there is nothing in any of the rest of the economic data which suggests a major change in patterns, so I give some credence to the possibility that 195,000 jobs were created by new businesses. In the US, most new jobs are created by small businesses, and in recoveries, it is normal for lots of new small businesses to be created. The jobs numbers are all guesstimates anyway, and it is the longer term trend and direction which should concern us, and not the month to month numbers. And lately, the trend has finally been good. #14 on Business Week My publisher sent me a note a few days ago, noting that Bull's Eye Investing is #14 on the Business Week Business Best Sellers list. I wish to thank all of you who have bought the book, and a special thanks for the many kind notes and reviews I have been getting. For those of you who have not yet bought, let me offer you the thoughts from one Mark Lemmons on Amazon.com: "Rarely does a book on the topic of investing and the economy qualify as 'can't put it down' material, but this one does - I finished it in a short weekend. Immensely readable, the book provides a framework for understanding an investment world that seems no longer to play by the rules. So many books of this kind come across as alarmist or naive, but Bull's Eye Investing is rational, methodical and comprehensive in its' analysis of everything from underfunded pensions to global demographic trends. The book left me with a 'bearishly optimistic' outlook for the next decade. Mauldin makes a compelling case for caution as a small investor, but also identifies strategies and analytical approaches that provide the reader with a path forward even in what he calls the 'Muddle Through Economy.' In the end, Mauldin's concise recipe for moving forward as an investor is nothing less than gourmet fare." Another reviewer kindly wrote: "The bottom line on Mr. Mauldin is that over the past few years following the advice contained in his weekly emails has made me a lot of money, even more important I have avoided large losses. Reading his weekly essay is a highlight of my week. Naturally the question comes up: why should I buy the book when I can get the data for free. Well, first is simple fairness: he deserves some pay back for dispensing so much wisdom for free every week. But hey, whose going to buy a book because the author deserves the money? Well, there are several good reasons. First the list of other free sources of investment/economic analysis available on the internet is worth the price of the book by itself. Second, there are several important chapters that have not been made available in his emails, and lastly the book organizes the data in a way that arms the individual investor with a broad intellectual base in which to put in context the daily stream of market data. Buy this book, and put in the time to fully understand it, and the reward will be many times the price of the book." You can read these reviews and others (some not quite as kind) at Amazon. The book is also at your local bookstores. Vancouver, New York, Orange County, Vacation I will be in New York next week, meeting with clients, doing some interviews and appearing Wednesday on CNBC with Ron Insana. In theory, I should be on between 2 and 2:30 Eastern time. I will be speaking the following
week at the World Gold Show in Vancouver June 13-14. I am looking
forward to it, as there will be lots of old friends there. It
is a free conference. For those interested in all things gold and anything to do with mining, you can find
the details here. And speaking of smart, my bride
has decided that I need a real vacation, and not the working
vacations that I seem to do. Evidently, she is noticing some
"stress faults" that need some repair. She has declared
that for 10-12 days, I will be somewhere with her and without
a computer commanding my day. Aah, but where in this wide, wide
world to go? We will look for cool and fun and relaxing. Since
my readers are among the smartest of all peoples, I am deferring
that question to you. Your 'really needing a vacation' analyst,
June 4, 2004 Copyright ©2004 John Mauldin. All Rights Reserved. John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Thoughts from the Frontline may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. This information
is not to be construed as an offer to sell or the solicitation
of an offer to buy any securities. |
