The Rise of Carry

Intro: The Nature of Carry

  • Modern economy is manifestation of rise of carry, not a function of economy or interest rates etc
  • Greater liquidity and USD center role as reserve currency has placed US markets (SPX) at center of global carry trade.

Central Banks Role in Carry

  • CB bankstop allows strong players and balance sheets to use leverage because they dont feel the full effects of carry crash.
  • Over time, the entire economy is intertwined with carry. Recessions are a function of asset price declines, not the other way around.
  • In the limit, central bank IS carry. We demanded it (politically).
  • Its converging. But to where?

Currency Carry Trades & Role in Global Economy

Currency Carry

  • Carry is short gamma. If inflows are going into carry currency, you are ok, even getting better. When it shifts, not only do you get weaker in terms of repayment, but economy gets weaker at same time = short gamma
  • The United States is NOT a natural carry trade funding currency because we have a current account deficit (import goods export dollars, need capital to fill the gap). Japan makes more sense, because they export goods and have a surplus of savings (to borrow in)
  • When carry trade funding takes place in USD, that just means more USD outflows the US has to replace with other capital
    • Other countries must acquire US assets (treasuries, etc)
  • Over time, Yen —> USD

Agents of Carry

  • Hedge Funds & Leverage
  • Sovereign Welath Funds - strong long lasting capital
  • Private Equity LBOs
  • Corporations (debt funded buybacks)

Nature of Carry

  • Carry Trades are Leveraged Trades
  • Carry returns increasingly correlated with Equity Carry (SPX)

Fundamental Nature of Carry Regime

  • SPX, which is deepest and most liquid market in world, has to be marginal provider of liquidity for global system
  • Includes volatility selling. Constant leverage IS selling volatility (short gamma)
  • Volatility is the value of money —> The SPX is the worlds hedge. Liquidity measure there measures marginal utility of money
    • Global volatility must be the most important and best paying risk factor in the world
    • Assets that suffer draw downs at worst times must have richest long run premiums
    • VIX measures marginal utlity of a dollar
  • Banks are the Largest Volatility Sellers (QE)

Monetary Ramifications of Carry

Monetary Regimes Are Deflationary

  • Too much debt, all else equal, withholding goes up, demand for credit drops
  • this negatively impacts long term growth

Business Cycle Carry

  • Oil carry traders, buy forward oil in the face of a downward sloping curve (backwardation). They are saying ok producers, lay your risk of lower prices off on me

Carry Bubbles and Ponzis have similarities

  • even at the late stage, in theory could make sense to participate as long as flows are coming in

Foundation of Carry in The Structure of Vol

Volatility Term Structure

  • Daily vol exceeds monthly vol (SPX is mean reverting to a degree)
  • buying the dip is profitable. why edge?
    • providing liquidity, carry trade
  • Market making is collecting a vol premium. If no vol, pocket money. otherwise, liquidity one sided, moves violent, lose money

SPX Itself is a Carry Trade

  • If SPX vol is expensive to realize, it is the spear of the global carry trade and VIX is a proxy for global vol

Alternative to Carry

  • What if liquidity were negatively priced? Ie cost money to provide?
  • long dated implied vols would go lower than short dated
  • but vol greater over long term than short term (inflation)
  • Anti Carry crash: inflation would spiral out of control as demand for true money collapsed (opposite of carry regime)
  • In both cases, market makes an uneasy truce out of a fundamentally unstable situation
  • The instability of fiat money itself leads to emergence of carry regime.
  • This is because some will have more power over others. Carry = power. Carry = rent seeking
    • central bank has monopoly on money
    • evolution of the system feeds into more and more reliance on carry
  • Carry regime - bubbles and then crashes that wipe out the least resourceful will always lead to continual inequality.

Carry is Power

  • Carry is cumulative advantage
  • Cumulative advantage is luck compounded
  • Cumulative advantage perpetuates itself
  • Cumulative Advantage is why we exist (evolution)

Carry is Everywhere

  • Root of carry = excess liquidity
  • Liquidity is ability to withstand shocks, negative uncertainties and keep going unimpaired
  • To be CEO or at the head of any hierarchy, pack of dogs, etc, is to be collecting carry

Globalization of Carry

  • Market "wants" to evolve towards more carry, the market will on average move this way (ultimate power is with voters)
    • stronger concentration of wealth and power
    • financial corporatism
    • strong central bank that acts to support share prices
  • Fed has exported dollar carry trade through swap lines during crisis. This is self reinforcing each bailout cycle
    • Market discipline is not being imposed
    • Economics is about expectation and how they are formed
  • It is not only difficult to hedge against a carry crash, its difficult not to get caught up in the carry trade in the first place

Beyond the Vanishing Point

  • eventually the carry regime will result in GDP being borrowed from the future so far in advance that trend economic growth is 0 and rates are zero or negative
Can it end before that point?
  • all signs point to monitoring inflation. with inflation, vol increases and central bank solvency increases
How do you tell between a crash and end of the carry regime?
  • Signs of the end, Vol edition:
    • Implied forward curves will settle into backwardation (lower longer dated)
    • Second, prices behave with momentum, not mean reversion (relaized vol higher longer dated)
    • Third, skew reverses, calls more expensive than puts
    • Most frightening: vol of vol would become much higher longer dated! This is crazy —> money is dying (getting progressively more uncertain over time)
What happens after carry regime?
  • inflation and anti carry, then ? crytpo?
  • need two things: cost to produce or claim on real economy
  • GFC 2008 was last chance to stop the carry train. it is too late now and the next two decades are bound to be tumultuous
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