"Carry Trades" and Trend-Following Strategies
Doug Nolan
The week commenced with yet another “flash crash.” The August 2015 version was notable for its ferocity and impressive global scope. Then there was the Dow’s 1,200 point “buy the dip” (and rip the bears’ faces off) rally from Monday’s lows. At Wednesday’s low point, the Shanghai Composite had sunk 18.7% from last Friday’s close, before a 13.4% rally left the index down 7.9% for the week. Currency markets, especially EM, were chaotic. From my perspective, the systemic nature of market dislocations provided decisive confirmation of the Global Financial Fragility Thesis.
Before diving into the present, let’s set the tone by reminding readers of an important but commonly unappreciated aspect of the Fed’s previous failed reflationary episode: Cheered on by “Keynesian” inflationist doctrine, the Fed specifically targeted mortgage Credit as the primary mechanism for post-tech Bubble system reflationary measures. In what was too surreptitious, government-directed mortgage Credit was unleashed to overpower deflation risks.
An historic expansion of mortgage debt ensued – too much of the risk intermediated, leveraged and obfuscated through sophisticated financial instruments and structures. Markets were distorted, risks were concealed and deep structural impairment was completely neglected. With the perception that Washington was backstopping mortgage Credit and housing, there was a breakdown in the market mechanism for pricing and allocating mortgage Credit. Fatefully, the marketplace completely lost its capacity to self-adjust and self-regulate. And that’s why they’re called Bubbles.
The Trillion dollar 2006 increase in subprime collateralized debt obligations (CDOs) financed near-panic buying of overpriced homes by borrowers of especially poor Credit standing.
Before diving into the present, let’s set the tone by reminding readers of an important but commonly unappreciated aspect of the Fed’s previous failed reflationary episode: Cheered on by “Keynesian” inflationist doctrine, the Fed specifically targeted mortgage Credit as the primary mechanism for post-tech Bubble system reflationary measures. In what was too surreptitious, government-directed mortgage Credit was unleashed to overpower deflation risks.
An historic expansion of mortgage debt ensued – too much of the risk intermediated, leveraged and obfuscated through sophisticated financial instruments and structures. Markets were distorted, risks were concealed and deep structural impairment was completely neglected. With the perception that Washington was backstopping mortgage Credit and housing, there was a breakdown in the market mechanism for pricing and allocating mortgage Credit. Fatefully, the marketplace completely lost its capacity to self-adjust and self-regulate. And that’s why they’re called Bubbles.
The Trillion dollar 2006 increase in subprime collateralized debt obligations (CDOs) financed near-panic buying of overpriced homes by borrowers of especially poor Credit standing.
“Terminal Phase” excess doomed the boom. By early-2007, pricing for a rising mountain of subprime mortgage paper had nowhere to go but down. Ditto for home prices. Perceptions of “Moneyness” for mortgage Credit had diverged wildly from the rapidly deteriorating soundness of the underlying loans. The 2007 reversal of “hot money” from high-risk mortgage Credit marked a critical inflection point for the mortgage finance Bubble, securities markets and economies. Yet as cracks initially appeared and Bubble risks were illuminated, perceptions solidified that policymakers would never tolerate a housing crisis. And despite such frail underpinnings, it all appeared sustainable – that is, so long as new “money” perpetually flowed in. “Perpetual” simply does not apply to human emotions, markets or finance more generally.
I have argued that “global government finance Bubble” excesses have been unprecedented – surely multiples of previous Bubbles. Officials globally employed central bank Credit and government debt in a desperate attempt to reflate global securities markets, general price levels and economies. And especially germane to today’s backdrop, policymakers doubled-down on failing reflationary policies back in the summer of 2012. This gambit has failed. Before it’s over I expect spectacular failure. Finally, the extraordinary divergence between inflated market expectations and deflating fundamental prospect has begun the arduous normalization process. The perpetual “money” machine now sputters badly.
Trillions flowed into all types of securities, financial instruments and strategies in response to government policy measures. Like never before, savers abandoned zero returns for perceived low-risk “bond funds” and equities. “Money” flooded the world in pursuit of easy EM returns.
I have argued that “global government finance Bubble” excesses have been unprecedented – surely multiples of previous Bubbles. Officials globally employed central bank Credit and government debt in a desperate attempt to reflate global securities markets, general price levels and economies. And especially germane to today’s backdrop, policymakers doubled-down on failing reflationary policies back in the summer of 2012. This gambit has failed. Before it’s over I expect spectacular failure. Finally, the extraordinary divergence between inflated market expectations and deflating fundamental prospect has begun the arduous normalization process. The perpetual “money” machine now sputters badly.
Trillions flowed into all types of securities, financial instruments and strategies in response to government policy measures. Like never before, savers abandoned zero returns for perceived low-risk “bond funds” and equities. “Money” flooded the world in pursuit of easy EM returns.
The ETF industry ballooned to almost $3.0 Trillion. Hedge fund assets, as well, swelled to $3.0 Trillion, buoyed by the perception of an industry prudently employing a low-risk “hedged” strategy.
“Moneyness of Risk Assets” has played a momentous role throughout the prolonged “global government finance Bubble” period. The Fed and global central banks inflated markets with Trillions worth of liquidity. Policymakers repeatedly intervened to quell incipient market unrest. With this as the backdrop, a huge industry – with enticing new products, structures and strategies - evolved around the world that promoted the notion that savers, investors and speculators could prosper as investors in global securities through liquid and safe (“money-like”) vehicles. And as evolving Bubble excess turned only more conspicuous, the market perception hardened that global officials would not tolerate another market crisis. The risks were too great.
This was particularly the case after 2012’s fateful “do whatever it takes” operations. In particular, ECB and Bank of Japan’s (BOJ’s) QE and currency devaluation measures incentivized what I believe to be historic “carry trade” speculative excesses. These extraordinary reflationary measures were complimented by – and were actually depended upon - Chinese policies. China’s officials moved forward with aggressive fiscal and monetary stimulus, while at the same time standing firm with their currency peg to the dollar. For its part, the Fed was determined to rectify every incipient bout of market instability. The Fed ignored mounting market excess in favor of maintaining its interest rate peg at zero. And the bigger the global Bubble inflated the deeper the faith in the global central bank market backstop.
I have argued that the underlying finance fueling the global boom has been unsound and unsustainable – that it is based on (“Moneyness of Risk Assets”) false premises and flawed perceptions. Dangerous misperceptions and attendant market Bubble fragilities are coming home to roost.
Monday saw the Japanese yen (vs. the dollar) trade in a range of 118 to 122, ending the day up 3.0% versus the US dollar. Yen “carry” trades – short/borrowing yen to fund higher-yielding instruments in other currencies – were severely bludgeoned. Monday saw the Australian and New Zealand dollars fall about 5% against the yen. The Russian ruble sank more than 5% versus the Japanese currency. The Colombian peso (down 4.2% vs. the dollar) fell almost 7% against the yen. Monday’s panic saw the Brazilian real, Indian rupee, Malaysia ringgit, Indonesia rupiah, Turkish lira and Chilean peso all suffer significant declines versus the yen. “Bloodbath” was used repeatedly to describe Monday’s action throughout EM currencies and securities markets. And with the euro gaining 2.0% versus the US dollar, popular euro “carry trades” were only a slightly less debacle.
By Friday’s close, most markets had reversed course and, seemingly, much had been forgotten.
“Moneyness of Risk Assets” has played a momentous role throughout the prolonged “global government finance Bubble” period. The Fed and global central banks inflated markets with Trillions worth of liquidity. Policymakers repeatedly intervened to quell incipient market unrest. With this as the backdrop, a huge industry – with enticing new products, structures and strategies - evolved around the world that promoted the notion that savers, investors and speculators could prosper as investors in global securities through liquid and safe (“money-like”) vehicles. And as evolving Bubble excess turned only more conspicuous, the market perception hardened that global officials would not tolerate another market crisis. The risks were too great.
This was particularly the case after 2012’s fateful “do whatever it takes” operations. In particular, ECB and Bank of Japan’s (BOJ’s) QE and currency devaluation measures incentivized what I believe to be historic “carry trade” speculative excesses. These extraordinary reflationary measures were complimented by – and were actually depended upon - Chinese policies. China’s officials moved forward with aggressive fiscal and monetary stimulus, while at the same time standing firm with their currency peg to the dollar. For its part, the Fed was determined to rectify every incipient bout of market instability. The Fed ignored mounting market excess in favor of maintaining its interest rate peg at zero. And the bigger the global Bubble inflated the deeper the faith in the global central bank market backstop.
I have argued that the underlying finance fueling the global boom has been unsound and unsustainable – that it is based on (“Moneyness of Risk Assets”) false premises and flawed perceptions. Dangerous misperceptions and attendant market Bubble fragilities are coming home to roost.
Monday saw the Japanese yen (vs. the dollar) trade in a range of 118 to 122, ending the day up 3.0% versus the US dollar. Yen “carry” trades – short/borrowing yen to fund higher-yielding instruments in other currencies – were severely bludgeoned. Monday saw the Australian and New Zealand dollars fall about 5% against the yen. The Russian ruble sank more than 5% versus the Japanese currency. The Colombian peso (down 4.2% vs. the dollar) fell almost 7% against the yen. Monday’s panic saw the Brazilian real, Indian rupee, Malaysia ringgit, Indonesia rupiah, Turkish lira and Chilean peso all suffer significant declines versus the yen. “Bloodbath” was used repeatedly to describe Monday’s action throughout EM currencies and securities markets. And with the euro gaining 2.0% versus the US dollar, popular euro “carry trades” were only a slightly less debacle.
By Friday’s close, most markets had reversed course and, seemingly, much had been forgotten.
After trading slightly below 118 on Monday, the yen weakened back to 121.71 (to the dollar) to close out the week. Most EM currencies and markets rallied sharply. Corporate debt markets, at the brink of serious liquidity issues on Monday and Tuesday, bounced back by week’s end. After trading up to 54 (high since the financial crisis) on Monday, the VIX (equities volatility) index was cut in half (to 26) by Friday’s close.
In a replay of previous “flash crash” scares (2010, 2012 and 2013), market tumult was met quickly with comforting comments from global policymakers. Importantly, ECB and BOJ officials stated their willingness to do more as necessary. These signals were instrumental in reversing yen and euro strength, alleviating fear of chaotic “carry trade” deleveraging. Global risk markets traded this week tick-for-tick with the yen. Doing his part, New York Fed President stated that the case for a September “liftoff” was “less compelling.”
At the moment, Monday’s panic appears yet another textbook buying opportunity. Markets were extraordinarily “oversold.” As conventional thinking goes, selling was based on irrational fear as opposed to actual fundamental factors. And in true bear market fashion, it appears bullishness will remain deeply ingrained even as the global bust gathers powerful momentum.
The pattern is well known. “Money” pours into risk markets based on the notion of abundant liquidity and policymaker backstops. And these risk distortions ensure booming markets and the availability of cheap and liquid risk “insurance.” Over the years I’ve used the analogy of “selling flood insurance during a drought.” All bets are off, however, when torrential rains eventually arrive. The reinsurance market immediately dislocates as speculators attempt to dump risk and hedge insurance they’ve sold. The notion of cheap and liquid insurance – so integral to boom-time finance – is invalidated. In the real world, dislocation in the risk “insurance” marketplace – with potentially profound implications for markets and economies – has come to be called a “flash crash.”
I believe myriad global “carry trades” – speculative leveraging of securities – are the unappreciated prevailing source of finance behind interlinked global securities market Bubbles.
In a replay of previous “flash crash” scares (2010, 2012 and 2013), market tumult was met quickly with comforting comments from global policymakers. Importantly, ECB and BOJ officials stated their willingness to do more as necessary. These signals were instrumental in reversing yen and euro strength, alleviating fear of chaotic “carry trade” deleveraging. Global risk markets traded this week tick-for-tick with the yen. Doing his part, New York Fed President stated that the case for a September “liftoff” was “less compelling.”
At the moment, Monday’s panic appears yet another textbook buying opportunity. Markets were extraordinarily “oversold.” As conventional thinking goes, selling was based on irrational fear as opposed to actual fundamental factors. And in true bear market fashion, it appears bullishness will remain deeply ingrained even as the global bust gathers powerful momentum.
The pattern is well known. “Money” pours into risk markets based on the notion of abundant liquidity and policymaker backstops. And these risk distortions ensure booming markets and the availability of cheap and liquid risk “insurance.” Over the years I’ve used the analogy of “selling flood insurance during a drought.” All bets are off, however, when torrential rains eventually arrive. The reinsurance market immediately dislocates as speculators attempt to dump risk and hedge insurance they’ve sold. The notion of cheap and liquid insurance – so integral to boom-time finance – is invalidated. In the real world, dislocation in the risk “insurance” marketplace – with potentially profound implications for markets and economies – has come to be called a “flash crash.”
I believe myriad global “carry trades” – speculative leveraging of securities – are the unappreciated prevailing source of finance behind interlinked global securities market Bubbles.
They amount to this cycle’s government-directed finance unleashed to jump-start a global reflationary cycle.
I’m convinced that perhaps Trillions worth of speculative leverage have accumulated throughout global currency and securities markets at least partially based on the perception that policymakers condone this leverage as integral (as mortgage finance was previously) in the fight against mounting global deflationary forces.
Yet massive securities market leverage is viable only so long as perceptions hold that government policymakers have things under control. And therein lies latent fragility. This explains why Central banks around the world vow liquid markets. The Fed must remain ultra-loose near zero rates, while upholding the perception that Yellen, Dudley & Co. will adhere to Bernanke’s doctrine of “pushing back against a tightening of financial conditions” (aka market risk aversion). The BOJ must continue with its massive QE program, ready to “push back” hard against a strengthening yen. Similarly, the ECB must convey that it is willing to boost and broaden its securities purchase program as necessary, also pushing back to suppress euro rallies. Chinese officials must be willing to adopt “whatever it takes” fiscal and monetary stimulus to sustain their faltering expansion – economic activity essential to the overall global economy. And importantly, China must be resolute in defending its currency peg to the dollar.
I’m convinced that perhaps Trillions worth of speculative leverage have accumulated throughout global currency and securities markets at least partially based on the perception that policymakers condone this leverage as integral (as mortgage finance was previously) in the fight against mounting global deflationary forces.
Yet massive securities market leverage is viable only so long as perceptions hold that government policymakers have things under control. And therein lies latent fragility. This explains why Central banks around the world vow liquid markets. The Fed must remain ultra-loose near zero rates, while upholding the perception that Yellen, Dudley & Co. will adhere to Bernanke’s doctrine of “pushing back against a tightening of financial conditions” (aka market risk aversion). The BOJ must continue with its massive QE program, ready to “push back” hard against a strengthening yen. Similarly, the ECB must convey that it is willing to boost and broaden its securities purchase program as necessary, also pushing back to suppress euro rallies. Chinese officials must be willing to adopt “whatever it takes” fiscal and monetary stimulus to sustain their faltering expansion – economic activity essential to the overall global economy. And importantly, China must be resolute in defending its currency peg to the dollar.
All the above are required to ensure stable market, financial and economic backdrops imperative to highly leveraged global “carry trades.”
I have posited that the global Bubble has burst. Fundamental to my analysis is that the above necessary conditions required to sustain global “carry trades” no longer exist. Faith has been broken that EM central banks retain the resources required to stabilize their currencies and ensure liquid securities markets. Importantly, confidence that Chinese officials have their markets, Credit system and economy under control has evaporated. Moreover, China’s recent devaluation badly undermined the perception of a strong and well-managed Chinese currency tied securely to the US dollar.
In previous bouts of “flash crash” market angst, policymaker assurances were successful in quickly quelling market worries and reversing illiquidity. A key dynamic has been repeatedly instrumental to market recovery and bull market resumption: global players respond to “risk off” upheaval by buying derivative “insurance” protection and boosting short positions and other hedges. And as we saw again this week, abrupt market reversals incite the rapid unwind of hedges and short positions. Short squeezes then quickly provide impetus for bullish panic “buy the dip” trading. This onslaught of buying power in the past spurred the global securities market bull to lunge upward.
There’s always been a game aspect to this trading dynamic. Markets disregard unfolding trouble for as long as possible. Eventually markets break abruptly lower, at least partially as a result of widespread hedging of market risk. Markets then reverse higher, with a large amount of put options and bearish derivatives expiring worthless. It’s been a repeating cycle. One of these days the markets may break lower when there are large quantities of bearish hedges in the marketplace. That is the scenario where “delta hedging” would see lower prices force additional selling (to hedge derivatives written) - that would then see lower prices and only more self-reinforcing selling.
Tuesday from The Wall Street Journal (Bradley Hope, Saumya Vaishampayan and Corrie Driebusch), under the headline “Stock-Market Tumult Exposes Flaws in Modern Markets:”
I have posited that the global Bubble has burst. Fundamental to my analysis is that the above necessary conditions required to sustain global “carry trades” no longer exist. Faith has been broken that EM central banks retain the resources required to stabilize their currencies and ensure liquid securities markets. Importantly, confidence that Chinese officials have their markets, Credit system and economy under control has evaporated. Moreover, China’s recent devaluation badly undermined the perception of a strong and well-managed Chinese currency tied securely to the US dollar.
In previous bouts of “flash crash” market angst, policymaker assurances were successful in quickly quelling market worries and reversing illiquidity. A key dynamic has been repeatedly instrumental to market recovery and bull market resumption: global players respond to “risk off” upheaval by buying derivative “insurance” protection and boosting short positions and other hedges. And as we saw again this week, abrupt market reversals incite the rapid unwind of hedges and short positions. Short squeezes then quickly provide impetus for bullish panic “buy the dip” trading. This onslaught of buying power in the past spurred the global securities market bull to lunge upward.
There’s always been a game aspect to this trading dynamic. Markets disregard unfolding trouble for as long as possible. Eventually markets break abruptly lower, at least partially as a result of widespread hedging of market risk. Markets then reverse higher, with a large amount of put options and bearish derivatives expiring worthless. It’s been a repeating cycle. One of these days the markets may break lower when there are large quantities of bearish hedges in the marketplace. That is the scenario where “delta hedging” would see lower prices force additional selling (to hedge derivatives written) - that would then see lower prices and only more self-reinforcing selling.
Tuesday from The Wall Street Journal (Bradley Hope, Saumya Vaishampayan and Corrie Driebusch), under the headline “Stock-Market Tumult Exposes Flaws in Modern Markets:”
“Monday’s mayhem exposed significant flaws in the new architecture of Wall Street, where stock-linked funds—as much as shares themselves—now trade en masse on U.S. markets. Many traders reported difficulty buying and selling exchange-traded funds, a popular investment in which baskets of stocks and other assets are packaged to facilitate easy trading. Dozens of ETFs traded at sharp discounts to their net asset value—or their components’ worth—leading to outsize losses for investors who entered sell orders at the depth of the panic. Products built to provide insurance for investors came up short. As a result of trading halts in futures tied to the S&P 500 index, it was difficult for investors to get consistent prices on contracts linked to them that offer insurance against S&P 500 declines.”
Bullish misperceptions regarding ETF liquidity are becoming too conspicuous to disregard. It is also clear that the hedge fund industry is really struggling in this market environment.
Bullish misperceptions regarding ETF liquidity are becoming too conspicuous to disregard. It is also clear that the hedge fund industry is really struggling in this market environment.
Crowded Trades are a serious ongoing problem. Clearly, way too much “money” has flooded into the ETF and leveraged speculation universes. Too much has inundated sophisticated derivative strategies that too often incorporate some component of trend-following behavior.
The scope of “money” following trend-following strategies is now an issue anytime markets are in the midst of a meaningful decline.
It’s an extraordinarily complex backdrop. Attempting to simplify things, a primary focus going forward will be the interplay between what I believe are faltering global “carry trades” and the massive amount of trend-following trading associated with bloated ETF, leveraged speculating community and derivatives complexes.
Previous market “flash crashes” quickly reversed course and worked to rejuvenated the bull market. Importantly, this was made possible by liquidity emanating from expanding global “carry trades” – notably from the yen and euro financing higher yielding EM and “developed” corporates, but also from “carry trade” leverage funneling “money” into the Chinese Bubble.
And the analysis has once again circled back to China. Chinese markets are broken and policymaking is discredited. Chinese officials may now appreciate the risk of breaking the peg to the dollar. At this point, however, maintaining the peg will require the People’s Bank of China to blow through it’s reserves to fund what will surely be massive financial outflows. And, suddenly, the market seems to have awoken to the likelihood that China and other EMs have evolved into major sellers of US Treasuries (and bunds, gilts, etc.).
It’s certainly worth noting the evolving dynamic in Treasury and “developed” sovereign bond trading. Treasuries just don’t benefit from “risk off” market tumult as in the past. Prices do, however, retreat quickly when “risk on” reemerges. This may prove an important dynamic.
It’s an extraordinarily complex backdrop. Attempting to simplify things, a primary focus going forward will be the interplay between what I believe are faltering global “carry trades” and the massive amount of trend-following trading associated with bloated ETF, leveraged speculating community and derivatives complexes.
Previous market “flash crashes” quickly reversed course and worked to rejuvenated the bull market. Importantly, this was made possible by liquidity emanating from expanding global “carry trades” – notably from the yen and euro financing higher yielding EM and “developed” corporates, but also from “carry trade” leverage funneling “money” into the Chinese Bubble.
And the analysis has once again circled back to China. Chinese markets are broken and policymaking is discredited. Chinese officials may now appreciate the risk of breaking the peg to the dollar. At this point, however, maintaining the peg will require the People’s Bank of China to blow through it’s reserves to fund what will surely be massive financial outflows. And, suddenly, the market seems to have awoken to the likelihood that China and other EMs have evolved into major sellers of US Treasuries (and bunds, gilts, etc.).
It’s certainly worth noting the evolving dynamic in Treasury and “developed” sovereign bond trading. Treasuries just don’t benefit from “risk off” market tumult as in the past. Prices do, however, retreat quickly when “risk on” reemerges. This may prove an important dynamic.
For one, despite the troubling global backdrop, Treasuries now appear to offer a less favorable risk vs. reward profile. Moreover, Treasuries these days seem to provide a less effective hedge against equities, corporate debt and EM market risks. And this may call into question the popular leveraged “risk parity” strategies that have proliferated in recent years.
One can go down the list these days and see serious cracks developing many of the most popular “investment” and speculative trading strategies. It sure appears the game is winding down. Is it possible that a lot of September put options and derivatives expire worthless? Of course. But that would basically change nothing. Global “Carry Trades” have begun a problematic unwinding. Liquidity will now be an issue. When it becomes a real issue, there’s going to be serious problems associated with all these Trend-Following Strategies. QE4 will be unavoidable. But it will have to be quite large to have much impact.
August 23 – Financial Times (Henny Sender and Robin Wigglesworth): “Investing: Whatever the weather? The risk parity strategy pioneered by Ray Dalio and driving a $400bn industry faces a stiff test if the Fed raises rates: The popularity of All Weather has helped the number and size of risk parity funds to swell in recent years, especially in the wake of the financial crisis.
AllianceBernstein, the US asset manager, estimated in a recent report that it is now a $400bn industry, and assuming an average 355% leverage ratio — derived from funds that issue public reports — control assets worth about $1.4tn. Even that figure is probably conservative, as it does not include discrete, in-house risk parity funds that have been established in some pension funds and insurers, which could easily bring the number up to $600bn, according to other analysts.”
One can go down the list these days and see serious cracks developing many of the most popular “investment” and speculative trading strategies. It sure appears the game is winding down. Is it possible that a lot of September put options and derivatives expire worthless? Of course. But that would basically change nothing. Global “Carry Trades” have begun a problematic unwinding. Liquidity will now be an issue. When it becomes a real issue, there’s going to be serious problems associated with all these Trend-Following Strategies. QE4 will be unavoidable. But it will have to be quite large to have much impact.
August 23 – Financial Times (Henny Sender and Robin Wigglesworth): “Investing: Whatever the weather? The risk parity strategy pioneered by Ray Dalio and driving a $400bn industry faces a stiff test if the Fed raises rates: The popularity of All Weather has helped the number and size of risk parity funds to swell in recent years, especially in the wake of the financial crisis.
AllianceBernstein, the US asset manager, estimated in a recent report that it is now a $400bn industry, and assuming an average 355% leverage ratio — derived from funds that issue public reports — control assets worth about $1.4tn. Even that figure is probably conservative, as it does not include discrete, in-house risk parity funds that have been established in some pension funds and insurers, which could easily bring the number up to $600bn, according to other analysts.”
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