DeJa Vu All Over Again: The Return of the Carry Trade and Implications

This summer the debt and equity rally continued with new strength. Evidence is new buying power is entering the market from leveraged lending similarly to the 2005-2007 asset rallies. In this case the likely lenders are US rather than Japanese banks though all the developed world is armed with cheap sources of lending. This is allowing the corporate sector to refinance on better terms and creating some incentives for investment spending.

Today is September 1, 2009. I would like to report on some new momentum in financial market pricing. As you all know, the credit crisis of 2008 led to an economic crisis. In that economic crisis, it further reinforced the downward movement of corporate debt, which reached the bottom of its pricing in December of 2008. Stocks continued down and reached a bottom in March of 2009. Since then, both have had powerful rallies in the marketplace. I’ve previously addressed this phenomenon to some extent. Video series 2, called “Market Exuberance” and the market update of a month ago, entitled “A Faith Based Rally,” laid out some of the reasons for the stock market advance despite the fact that the economy was barely improving. There is a growing divergence between the behavior of the financial markets and the underlying strength of the economy which generates the revenues for corporations to make good on their claims.

Now the question is, “What in the world might the market have been pricing?” Laying out a few of the issues, and there are several, there are almost a half dozen of them. First of all, the expectation of recovery following Fed action is something that the financial market participants learned from many years of post World War II recessions, and it is something I call “the faith based rally,” the faith that, if the Fed moves, the economy in turn will be cured, and the corporate cash flows and profitability will improve and stock prices will improve. Another reason for the market turnaround in the absence of an economic turnaround is the Fed engaged in lending directly to private firms who were unable to raise money in the private debt markets. By doing so, they avoided the imminent bankruptcy that these firms were facing if unable to roll over existing debt. So effectively, the Fed refinanced corporate debt which gave them a new lease on life to manage their way through a recession. Other reasons to account for the sharp rallies include money managers not wishing to have their performance be reflected negatively, because their performance is an evaluation of how they did relative to a market benchmark. If indeed, the market is rising and they do not participate in the rally because they have no faith in the underlying fundamentals, they will be left on the sideline, compromise their ability to keep even with their market benchmark and endanger their jobs. So money managers, whether they believed in the economic resurgence, had to jump into the financial resurgence, no matter what. Another reason, and this is a real reason that we have some economic advance taking place or some support for the economy coming out of all this, is that, to the extent financial market participants who jumped into the market on faith or expectations or some way were forced to do so, created higher prices of debt and equity. In return, what that did was it allowed corporations to restructure their capital structure. They could add more equity. They could sell equity and pay off debt. They could refinance debt to longer maturities, and likely at a lower interest rate. So the companies have now more favorable capital structures as a result of the exuberance shown by investors in financial markets. It has enabled the corporations to eliminate the fear of imminent recession because in recession, when cash flows are minimized, they now, at least, have the ability to service a smaller debt load.

In addition to all those reasons, there is yet another powerful reason for the market rally, and that is that there has been, without question, a short covering rally to unwind short positions that existed in the market. The method for doing so is to buy a stock to cover your short position. So this forced those who were pessimists to become, in effect, optimists and throw money into the market. So we have had, in all, five reasons for some technical and faith or sentiment reasons to participate in the market. So all of those things were in place by, let’s say, June or so.

Summertime, the months of July and August, yet brought a new wave of buying. The question becomes, “What, indeed, was behind this yet new wave of buying?” Well, this is something that we have known before, we have known about or observed for about the last 15 years, a phenomenon called the Carry Trade. As the title of the newest link that I have posted, the subtitle is, “The Carry Trade and The Global Monetary Credit Transmission.” Basically, the Carry Trade is associated with financial firms borrowing at very low interest rates from Japanese banks, which have occurred from the early 1990’s to 2007, and in turn, leveraging up and buying into the financial markets. Effectively, Japan, for a good long time, since the early1990’s, has been in a deep recession and monetary ease has existed in that country where indeed, the central bank would lend to a commercial bank at a zero discount rate, who in turn could perhaps charge 2-3%, lend to a USI-bank or hedge fund or private equity firm, and if they were able to purchase assets yielding a rate higher than the very low rates being charged by the Japanese lender, they could earn a spread. It worked so well that the financial interests added to their leverage position continuously. As it worked, they added more and more leverage. Finally, by 2007, basically the financial community was levered approximately 30 to 1. Now what we then had, following that amplification of leverage, was a highly amplified downturn, and that is indeed what leverage does, and it is a problem, and it is a threat to the future. Basically, it is deja vu all over again.

Just two years ago, or even a year ago, we were unwinding losing leverage plays and here the lenders and the borrowers are back at it again. This was very much behind the asset bubble of 2005 through 2007, which came crashing down in 2008. This time, the Carry Trade and leverage is a little bit different. Instead of the U.S. firms necessarily going to a Japanese bank to borrow, since all the developed countries of the areas of the world simultaneously had this economic recession, money is cheap everywhere. It is true with the Bank of England, the European central bank, the Bank of Japan, and the Federal Reserve. So basically, the leverage Carry Trade has become simpler because one does not need to borrow in the Japanese currency and need to repay in the Japanese currency and hence take foreign exchange risk. One could borrow in the dollar and invest in the dollar and the only risk one has is the debt market does not continue to rise or the stock market does not continue to rise. But we now have yet more reason and less risk to enter into leveraged financial plays.

Now the good news about all this is that there are some real effects that are coming out of it. The good effects that are coming out of it are the refinancing of the corporate balance sheet has left them less vulnerable to recession; their carrying power or their holding power through a recession is greatly enhanced, and furthermore, with a very low cost of capital, it is possible we might have real economic effects that come out of it; namely, investment spending. This takes place simply because if a firm has a low cost of capital, there are more projects that make sense on an economic basis to be financed and undertaken. In this case, it is likely that the monetary transmission mechanism is not the central bank lending to commercial banks who, in turn, lend to consumers who, in turn, buy a durable good and lead us out of a recession. In this case, it is more likely that the low cost of capital available only to the business firms that can participate in public debt markets and public equity markets, they then have a lower cost of capital and more investment projects start to make sense to them. It strikes me as the possibility that we might conceivably have an investment-led economic recovery, eventually, out of all this, as opposed to the typical consumer-led, bank-borrowed recoveries that we have had in the past.

Now on top of that, we have not only the irony of the return to the asset bubbles and leverage in financial markets, but we also have another irony in this situation, and that is we have the Fed entering into a very tough, conflicted spot. The Fed still has its traditional role of lending to avoid economic recession and to avoid unemployment, and they are doing that mightily. On the other hand, the effect of trying to prevent unemployment is to create an asset bubble. Now, very shortly, the Fed will be given by Congress the responsibility to prevent asset bubbles, and here the solution to the unemployment mandate is to create an asset bubble which soon they will be in charge of avoiding, which puts them in a deep conflict. Basically, they are going to have to make tough decisions. To the extent they move to stop the asset bubble, they will endanger the economy and the elimination of unemployment. So what we have is a new reality in the market where basically the Fed has more goals and more problems they have to take care of than they have tools to take care of those problems. They are going to be in a very deeply conflicted position of having to make the tough choice as to which of these two conflicting goals to favor. Do they favor a strong economy to get rid of the unemployment or do they favor getting rid of asset bubbles so that we do not have a repeat of 2007 and 2008?

Well, in approximately six months, we’ll find out, because it will probably take that long before these additional responsibilities are given to the Fed and Ben Bernanke, who has been re-nominated for his re-appointment as Chairman, goes through the confirmation hearings. It probably will not be until February that the Fed has to address that conflict. In the meantime, I think we can expect continued asset bubbles emanating from Fed easy money.

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