The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (BUSINESS BOOKS)

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Of course, “solvent but illiquid” is exactly the situation SVB was said to be in. Expect to hear this messaging a lot more in the coming years. The line between market support and QE will become increasingly blurry and, as it does, the risk of much higher inflation will increase. Now, if you believe everything that was previously said, and thereby having established a coherent link between carry trades and the dual prongs of the fed, you come to some sobering realizations; namely: At first glance an unhedged short volatility position has no effect on the market. But it is very likely that an unhedged trader has sold their options to a market maker, who will usually be delta hedged (unless they are young and callow). The market maker is long volatility, and hedges by selling as the market rises, and buying on dips. They will reduce the volatility of the market. The financial shelves are filled with books that explain how popular carry trading has become in recent years. But none has revealed just how significant a role it plays in the global economy--until now. The book only briefly mentions the accumulation of moral hazard. However, in my opinion, this is where the main problem lies. In the institutions that run the society, the proportion of idiots has been steadily increasing for many decades. It is now close to 100%.

This is a very ambitious book, and in places its ambition causes it to overreach. Carry is a fundamental part of the markets, and to some degree in the economy as a whole. But linking it to human evolution as the authors do in the final chapters, seems rather tenuous to me. Nevertheless, this is an important book. Carry is important, and is not going away. It will always be an attractive strategy. He currently lives in Oakland, California with his wife Jody and their four children and has as a moderate-to-severe obsession with tennis. In 2002, he moved to California to co-found Algert Coldiron Investors, a quantitative equity specialist managing both hedge funds and long-only strategies. ACI was consistently ranked by alternative investment consultants as among the best equity market neutral managers globally. The financial shelves are filled with books that explain how popular carry trading has become in recent years. But none has revealed just how significant a role it plays in the global economy - until now.

Tim Lee and Kevin Coldiron

What is a Franken-Bull? It’s a term I came up for a market that has bearish fundamentals, but experiencing a bull run. Both the extremely high level of the equity market, which cur­rently matches the previous peaks of 1929 and 2000, 18 and the low level of volatility over the past decade, indicate that we face a high risk of a major bear market. The Rise of Carry provides a timely des­cription of how this situation has arisen and an urgent warning of dangers ahead. This article originally appeared in American Affairs Volume V, Number 2 (Summer 2021): 46–59.

But, as the authors point out, carry trading is not limited to rogue traders. Collecting steady premia is what an insurance company does. Banks, who borrow and lend to earn an interest rate spread, are also carry trading. But insurers and banks diversify across many customers, transforming a portfolio of risky bets into a benign balance sheet. In contrast, most carry trades in the financial markets are correlated in market crashes, so true diversification is hard to find.

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The authors do not make this distinction sufficiently clear, defining carry as a trade with ‘short exposure to volatility’. This is correct for short volatility trading, but not for FX carry where only volatility in the wrong direction is problematic. But perhaps I am being too pedantic. Higher yielding currencies are usually emerging markets. These get hurt when risk levels are elevated, whilst lower yielding currencies are normally ‘safe havens’ like the US and Japan. In this book we define all carry trades to share certain critical features : leverage, liquidity provision, short exposure to volatility, and a “sawtooth” return pattern of small, steady profits punctuated by occasional large losses (p. 3, LL&C). For those of you perma-bulls questioning the basis of “bearish fundamentals:” If headlines such as: Tim Lee is the founder of the independent economics consultancy pi Economics, serving financial institutions from hedge funds to traditional asset managers. Previously he worked for global asset managers including GT Management and Invesco in Hong Kong and London. He is the author of the highly regarded Economics for Professional Investors (2nd edition, 1998) and his commentaries and analysis have been widely quoted in the media. Tim was educated at Magdalene College, Cambridge University.

This fact leads to a pernicious feature of carry. Leverage increases the risk of ruin, and carry involves leverage. Carry drawdowns are therefore likely to involve the risk of some participants facing ruin. This means the aggregate growth of carry is likely to represent a systemic risk to the financial system. It is therefore no accident that the increased involvement of central banks as lenders of last resort has coincided with the growth of carry. They are intimately linked (p. 72, LL&C)” the markets triggers central bank action to stabilize markets, reduce volatility, and ultimately truncate losses for some carry traders who would otherwise have been bankrupted (p. 37, LL&C). Financial instability has thus risen as the carry trade has grown. The Rise of Carry does not estimate the size of the market, for which reliable data do not seem to be available, but the authors argue convincingly that it is very large and has expanded greatly in recent years. They also point to the risk that volatility in different financial assets may be contagious: “There is also evidence of a growing correlation between currency and equity market carry, suggesting that a single global volatility risk factor may be a driver of all forms of carry in the future. If this is true, future carry crashes may impact on all asset classes at the same time.” 7 Traders do not especially care their strategies affect the operation of the market more generally, but the authors do explore this interesting facet of the carry story. I particular enjoyed their description of selling vol at short durations, then buying it at long durations. This nicely fits certain stylised facts of market behaviour: mean reversion at shorter horizons, and momentum at longer horizons.Leverage also forms an important part of the definition of Carry as defined by the authors. FX carry trades often yield a desultory sum, like the 2% a year currently available from the USD/EUR pair. This would need to be leveraged several times to get a reasonable return. Naturally, option selling is an inherently leveraged activity. As the authors rightly say, the use of leverage is a key characteristic of carry trades. A carry trader who uses no leverage can ride out any storm. But with high leverage, the slightest adverse price movement will wipe them out. Carry as trading strategy For most of the twentieth century, the neoclassical synthesis in economics was generally believed to provide a solid basis for public policy. There were, nonetheless, significant dissenters. Hyman Minsky, for instance, wrote that “modern orthodox economics is not and cannot be a basis for a serious approach to economic policy.” 1 In the wake of the financial crisis and the great recession of 2008, such questioning became even more vociferous, and criticisms like Min­sky’s are now increasingly accepted. He began his career in quantitative finance in the early 1990’s with Barclays Global Investors in London. At BGI he became head of European research and later founded their European hedge fund business and co-managed the UK and European equity market neutral funds. Volatility insurance differs in one important respect from other common forms of insurance (such as life, home, and vehicle insurance), which allow the specific risk of events to be pooled. In these forms of insurance, the aggregate risks taken by insurers are significantly less than the sum of the individual risks. Homeowners who buy fire insurance, for instance, pay regular premiums and are pro­tected thereby against loss. The number of houses destroyed by fire annually does not vary much from year to year, and so the insurance industry’s total income is sufficient each year to pay for the individual costs without being at risk of significant overall loss, although profits will fluctuate as fire damage varies from year to year. But this common sort of risk pooling is not characteristic of the carry trade, in which the aggregate risk is systemic rather than specific.