"Hostage Of The Carry Trade Bubble"

BEST OR KURT RICHEBACHER

December 1, 2004

HOSTAGE OF THE CARRY TRADE BUBBLE

While the Fed has raised its federal funds rate from 1% to 1.75%, longer-term interest rates simultaneously went in the opposite direction. The consensus sees the positive rationale in quiescent inflation and inflation expectations.

Our rationale is different: The sharp decline in long-term rates has its primary cause in the Fed’s continuous, extreme monetary looseness fueling a new wave of carry trade. Though its rate hikes have made the carry trade play more expensive, the spread between funding costs and returns, determined by the difference between short-term rates and longer-term bond yields, remains quite attractive, in particular when market participants perceive little or no risk of a rise in long-term rates, which would quickly destroy the market value of their highly leveraged bond holdings.

In essence, two reasons mainly have led market participants to discard any risk of rising long-term rates. One is disappointing economic news, and the other is Mr. Greenspan. They have realized that the Greenspan Fed is effectively hostage to the carry trade bubble.

Running into trillions of dollars and involving an enormous part of corporate and financial America, the pricking of this asset bubble would spell financial apocalypse for America. It would trigger a fire sale of unimaginable proportions in the bond market, with bond prices crashing and yields soaring. Mr. Greenspan must be desperate to avoid this. It implies further that a return to "normal" short-term interest rates in the United States is completely out of the question, even if rising inflation rates or a collapsing dollar would urgently demand it.

Manifestly, the potential bond buyers needed to accommodate the potential sellers involved in the carry trade will not exist when the day of reckoning arrives. Liquidity will disappear overnight. Be prepared for double-digit U.S. long-term rates.

In short, U.S. monetary policy is inexorably stuck with artificially low interest rates.

Intrinsically, a weakening economy should boost further carry trade in bonds, and thus lower long-term rates. But a new, outright economic downturn will come as a rude awakening from prior complacency. Earlier, we said it might cause a cataclysmic shock. In the first place, it would hurt the other two asset bubbles, housing and stocks, and also the dollar bubble. Altogether, this would surely generate general uncertainty and turmoil in the financial markets, affecting the bond market negatively, too.

It is for two reasons, really, the most vulnerable and the most dangerous bubble. It is most vulnerable because any rise in long-term rates will prick it; and it is most dangerous because this would trigger immediate collective unwinding of positions running into trillions of dollars. It could devastate the whole financial system. No responsible central banker would allow such a bubble to develop.

The big problem lies in the fact that with a usual leverage of 20-to-1, even minimal rises in bond yields may endanger the capital of a yield-curve player. Another big risk looms in a widening of credit spreads. Given the unusually low level of yields, many players have shifted to higher-yielding junk bonds. One of the results has been a drastic narrowing of the yield spread. With a weakening economy, these spreads would certainly widen again.