Getting Carried Away
by Rob Kirby, Kirby Analytics. March 27, 2006
The Federal Reserve's interest rate setting policy group, the Federal Open Market Committee [FOMC], is set to meet this week amid expectations that they will raise the Fed Funds Rate for a 15th straight time from 4.50% to 4.75%. Tuesday's meeting will be the first such chaired by Ben Bernanke.
As Bloomberg's Caroline Baum points out in last Monday's [March 20/06] address before the Economic Club of New York, Mr. Bernanke might have been appalled at how major news outlets received "mixed messages" as to his intent where interest rates are concerned.
Ah, the weight of a few words can be a lot for one man to carry. Well chosen – they are of little significance, unless of course you happen to be the Chairman of the Federal Reserve – in which case every syllable is scrutinized as to hidden meaning. Nowhere do the utterances of Ben Bernanke and the interest rate policy statement of the FOMC have more bearing than for the prospects of the Carry Trade.
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Bond Carry Trade
POSITIVE CARRY: NORMAL YIELD CURVE
With short term rates having risen 14 times already and long term rates [10 yr.] having remained more or less range bound between 4.00% and 4.70%, there's been a good deal of speculation in the financial press that a flattening/inverted yield curve would bring an end to the bond carry trade. For those who may not be aware, the bond carry trade involves "lending long" and funding short. Jim Puplava has written extensively about the bond carry trade in The 'Carry Trade' Economy from his Storm Watch Series of articles. But the reality is - many people think of the Carry Trade strictly in terms of "Bonds" or interest rates. But they come in other "flavors." I would like to take a moment to highlight a couple of other identifiable "Carry Trades" that institutions and hedge funds dabble in that investors should remain cognizant of also.
NEGATIVE CARRY: FLAT OR INVERTED YIELD CURVE
The Bond Carry Trade With A Yen Twist
In an illuminating article written by John Succo over at Minyanville.com titled, Carrying The World, Succo explains how in a "liquidity driven" environment like our current financial world – many institutional investors are under increasing pressure to produce higher returns. To meet those demands, Succo explains,
"…these firms are taking extraordinary risk in one place to get those returns, and at the same time, that place is fostering the world's liquidity on which asset prices are so dependent.
It's the carry trade, and it's simple in its construction and its danger."
The Yen Carry Trade [which works much the same way substituting Swiss Francs] is really just the Bond Carry Trade with a "twist" – where "investors" raise money in Japan – typically for ten years at a time by "shorting the 10-year yen government bonds" which currently yield in the neighborhood of 1-1/4% – which reflects the financing-cost-in-yen per year to the borrower. The yen balances are then "swapped" for U.S. Dollar balances where they are "invested" at current rates around 4.75% - with a seeming "pick up" in yield of 350 basis points for their trouble.
A potential problem occurs, however, at maturity – when the trade needs to be reversed and the Dollars need to be converted back into Yen to repay the loan. If the Yen has appreciated against the Dollar by any more than 3.50% - not only is the "perceived" 350 basis point "pick up" vanished – but the investor is staring at potential losses, possibly big ones.
As Succo points out,
"Amazingly it turns out that if the fund manager wants to hedge against the risk of the [yen] rising, all those 'profits' he expects to earn are exactly offset by the hedging costs. In other words, the whole trade is really a sham: there is no free money and the fund in actuality is taking a huge amount of currency risk."
Succo argues that historically – unlike today – macro capital flows between countries like the U.S. and Japan took place on a basis that adequately accounted for the risks being taken. Today, he argues, these risks are largely ignored.
Hats off Todd Harrison, the CEO and founder of Minyanville.com along with the rest of his knowledgeable street savvy staff - because in Succo's words,
".. the site is about telling the truth and breaking down wall street's sales machine".
The Gold Carry Trade
With the Gold Carry Trade, typically Sovereign gold bullion is "borrowed" from a Central Bank for rates that would typically make Yen borrowing costs seem exorbitant [less than 1 % per year]. The bullion is then sold into the spot market either privately or on a recognized exchange like N.Y.'s COMEX and the proceeds from the "sale" are then invested at market rates with the "pick up" in yield accruing to the borrower of the bullion.
These transactions are typically "arranged" for a fee, by Bullion Banks like J.P. Morgan Chase or Goldman Sachs. A great deal of this type of transaction occurred throughout the 1990's when gold was priced at less than USD 300.00 per ounce.
Many institutions that were tempted into this trade were gold miners themselves, many of whom legitimately booked these trades as "hedges" to their future production. In some cases, like Barrick Gold, these institutions sold as much as 16 million ounces "forward" or more than 3 years worth of total mine output [5 million ounces mined 2004 basis] – casting a shadow of doubt on the true intent or prudence of maintaining such a large hedge book/short position.
This type of carry trade becomes problematic or maybe even lethal when the price of gold rises – like it has over the past five or so years – and, if to repay the bullion at maturity, the borrower is ever forced into the "spot market" to buy/cover his short position to repay the physical bullion they originally borrowed.
So just remember, with the Carry Trade – as with a good many things in life – there's often a little more to it than originally meets the eye.
Overseas equity markets began the week on a positive note with Japan's Nikkei Index gaining 89 points to close at 16,650. Meanwhile, North American markets didn't fare as well with the DOW losing 29.70 to 11,250.27, the NASDAQ up 2.80 to 2,315.60 and the S & P off by 1.35 to 1,301.60. NYMEX crude oil futures gained .18 ending the day at 64.34 per barrel.
The U.S. Dollar Index ended the day flat at 89.69. The Dollar did decline, however, against the Chinese Yuan – ending the day at 8.0214 from roughly 8.03 at Friday's close.
Interest rates inched higher with the benchmark 2-year bond ending the day at 4.75%, the 5-year at 4.70% and the 10-year also at 4.71%.
In the precious metals arena, COMEX gold futures closed up 6.60 at 567.50 while COMEX silver futures ended the day up .17 at 10.91 per ounce. The XAU Index added 3.85 closing at 137.25 while the HUI gained 10.73 to close at 324.75.
On tap for tomorrow, at 10:00 a.m. the Conference Board is due to release March Consumer Confidence data – expected 101.0 vs. prior 101.7. Then at 2:15 p.m., the FOMC is due to release their decision on short term interest rates, expect to raise the Fed Funds rate by .25 to 4.75%. Also closely watched will be the language in the policy statement that accompanies the interest rate decision.
Wishing you all the most pleasant of evenings and a happy Fed Rate Decision Day tomorrow!
© 2006 Rob Kirby