The End of the Carry Trades Will Hurt

 | Oct 11, 2011 | 3:52 PM EDT
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Over the past few months I've written about the financial impact of a flat U.S. Treasury yield curve on the insurance industry. In this column I will review more broadly the consequences of a flat yield curve on the global economy and the related threat to financial markets.

The single most important global macro issue to be aware of today is the simultaneous flat sovereign bond yield curves in Japan, Germany and the United States. This is a very rare event with extraordinary implications for the global economy and capital markets.

The first market to go flat was Japan. That process started around 1995 when the 10-year yield was about 5%. By 1998 it had declined to 2% and has moved back and forth between 1% and 2% since.

The curve flattening in Japan also gave rise to the yen carry trade, which continues today. The most basic yen carry trade is the borrowing of money in yen at low nominal rates, typically by Japanese nationals, converting the currency into U.S. dollars or euros and investing it in the sovereign bonds of the U.S. or Germany. As the long-end yields in Germany and the U.S. for most of the past 13 years since Japan's long-end yields collapsed were still high, Japanese citizens could put on a yen carry trade to create financial return.

This process was an unintended consequence of the monetary and fiscal stimulus that caused the curve to flatten in Japan. Japanese stock prices collapsed in 1990. Within a few years the resulting drag on economic activity caused real estate prices to collapse. The economy entered recession and actually began to deflate. The corrective action -- the monetary and fiscal stimulus -- was supposed to attract borrowing, lending, investing and consuming in Japan. The export of capital and the yen carry trade were not supposed to happen.

The yen carry trade, however, has now become a structural phenomenon in Japan, with financial organizations, companies in general and individuals becoming adept at managing carry trades for financial gain.

The other big result, though, has been that the domestic Japanese economy has stagnated. The GDP in Japan today is essentially where it was in 1995 in nominal terms. It's been called the lost decade but it's really the lost generation -- and it shows no signs of stopping.

The aggressive lowering of short rates in the U.S. by the Federal Reserve over the past few years has also given rise to the U.S. dollar carry trade. That trade has been seen most clearly in money flowing into commodities and stocks, but it has also been felt in illiquid markets like raw land, art, diamonds, etc.

As the curves in Germany and the U.S. are now flattening, with 10-year sovereign yields approaching parity across all three countries, carry trades of all kinds will be much harder to manage or put on from now on.

The Japanese will most likely continue to attempt to game the markets with carry trades by converting into second- and third-tier currencies -- the Australian and Canadian dollars and the Brazilian real, among others. It is unlikely that this same phenomenon will occur in the U.S. and Germany (or Europe more broadly), though, as the multiyear history and comfort level with the concept does not exist, as it does in Japan.

I expect activity in the global financial sector to decline as borrowing and lending for carry trade purposes decreases. Less lending will be reflected as lower GDP in the official numbers as reported by countries too.

It will appear as though the world economy is beginning to slow very rapidly. The reality is that real economic activity has been slowing since 2008, but that trend has been masked by the increase in financial transactions -- the carry trades.

There is a real impact, however. Global financial firms have generated the bulk of their revenue and earnings since 2008 by putting on carry trades for themselves and lending to their clients to do the same. This revenue will decline just as the financial firms need more capital to absorb losses on sovereign and other debt -- especially in Europe -- setting up a financial crisis similar to 2008.

Tomorrow I will discuss the probable course of action the Europeans will take in recapitalizing their banks and the potential impact on U.S. and other banks.

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