Long before anyone had heard of the coronavirus, Kevin Coldiron—a former hedge fund manager and lecturer in the Berkeley Master of Engineering Program—was concerned about what a big shock to the financial system would mean to the markets and the economy. Although economic indicators were strong, corporate debt was at an all-time high, due primarily to companies issuing bonds to buy back their own shares and bump up stock prices. Meanwhile, Federal interest rates were already low, having been cut three times in 2019 to keep the decade-long bull run going.
Those are all symptoms of what Coldiron calls “the rise of carry”—referring to a formerly niche strategy that, he argues, has grown into a ubiquitous global investment theme. In a new book, The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (McGraw-Hill, 2019), Coldiron and co-authors Tim and Jamie Lee make the case that carry trading is a driving force behind growing inequality and periodic market crashes.
After gaining several favorable reviews, the book jumped to the #1 bestseller spot in three business book categories on Amazon earlier this spring.
We asked Coldiron, who teaches asset management and factor investing in the MFE program and was an early pioneer in algorithmic trading, to explain what carry investing is and what role it’s playing in the current market turbulence.
Why did you write this book?
We have this textbook version of how the markets ought to work, but we have globalization, we’ve got much more sophistication with derivatives, we have central banks behaving in ways they never have before. Our financial system has changed, and I hope to get people to better understand that.
I’m guessing I’m not alone in having never heard of carry trading before reading the title of your book. What is it?
You can think of a carry trade as a trade that makes money if nothing happens. Carry trading first gained a lot of traction in the currency markets starting in the 70s and 80s. The idea is that you borrow at a low interest rate and invest in a higher interest rate. If interest rates are 0% in Japan and 5% in New Zealand, you can borrow yen at zero and invest in New Zealand dollars at 5%. That’s a profitable trade, particularly if you lever it up multiple times, which people do. The risk is if the exchange rate moves against you. If you have a leveraged position, a small change in the exchange rate can quickly wipe out your yield advantage. So with carry trades, if the world stays stable, they can be very profitable. But when volatility increases, they can turn unprofitable very quickly.
You can think of a carry trade as a trade that makes money if nothing happens.
How is that different from other kinds of leveraged trading?
You can have a leveraged directional trade, for example, where you bet that the market is going to go up. That’s not a carry trade, because if nothing happens, you’ll lose money because that leverage is expensive. Leveraged directional traders have to trade with the market: If the price goes down, for instance, they need to sell or their leverage explodes. Carry traders take the other side of those trades—they trade against the market, providing liquidity and accepting the risk that prices keep moving in the same direction.
You likened carry trading to selling insurance.
It’s similar in many ways. If you sell me life insurance, I send you a steady stream of income every month. Then occasionally, if something happens to me, you have to make a big payout. As long as you’ve set up your business and you have reserves to cover those big losses, we both benefit. You have this profit profile of steady gains punctuated by occasional big, unpredictable losses—a sawtooth pattern. That’s why insurers are regulated: You can’t sell insurance without proving that you can cover the losses. The difference is that in the financial markets, you don’t have to prove you have the ability to cover the full losses.
…In the financial markets, you don’t have to prove you have the ability to cover the full losses.
How has carry trading grown?
What started in the currency markets with borrowing in low-risk or low-interest-rate currencies has spread to the equity markets. An example is corporate share buybacks. We classify that as a carry trade. They’re essentially doing kind of a levered yield spread, issuing cheap debt to buy back their own equity at a higher yield. What private equity companies do with leveraged buyouts is very similar. Again, they’re issuing cheap debt and they’re buying companies that have a higher earnings yield. There are also more direct ways that we see this happening with volatility trading in hedge funds. As you can imagine there are a variety of more sophisticated ways to construct these trades, but at their core they are all exposed to big increases in volatility.
Private equity and hedge funds and share buybacks were relatively small in scale 20 or 30 years ago. Hedge funds were really tiny players in the market, and now they manage something like $3 trillion in assets—and that understates their impact because those assets are levered up and they trade very frequently. Twenty-five years ago, their impact on the financial system was at the margins. Now they’re right at the core.
Twenty-five years ago, [hedge funds and private equity’s] impact on the financial system was at the margins. Now they’re right at the core.
How are we seeing the consequences of this play out right now?
The airlines are an interesting example. Ben Hunt at Epsilon Theory calculates that the big four U.S. airlines bought back $42 billion of their own stock over the last six years, while increasing their debt by 78%. The CEOs personally pocketed $430 million from this on top of their normal compensation. These companies now have no financial cushions and have just been rescued by a U.S. government loan.
Movements in the currency markets were exactly as we’d predict. In the early days of the crisis, both the yen and euro initially rose very sharply against the dollar. Why? Because these are very liquid markets with ultra-low interest rates—ideal places to borrow to fund long carry trades in high-yielding emerging market currencies. When the crisis started, the emerging market currencies began to depreciate and the yen and euro carry trades started losing money. To stop more losses, these trades were closed quickly and that involved buying both yen and euros, which caused them to rise in value sharply.
Later, those gains were reversed as we entered the next stage of the carry crash—the rush for dollars. When things get really bad in our global financial system, the only true safe asset is U.S. dollar cash. Banks in Japan and Europe needed dollars and as they sold their own currencies to buy them, the yen and euro fell. Eventually, the Fed had to open swap lines with a range of foreign central banks to provide them access to dollars. This was an exact repeat of 2008, and a clear example of the Fed having to replace private carry capital in order to stabilize the markets.
Has carry trading increased market volatility?
I would say it amplifies fragility and hides unrevealed risk. As the amount of carry trading increases, it makes it appear as if the system is much more stable than it is, because there’s more liquidity out there and less volatility. But it’s hiding an unrevealed risk, which we see in episodes like 1998, 2008, and now.
Carry traders are very vulnerable to volatility. And because their positions are levered, carry traders only have the ability to withstand a modest amount of losses. So when volatility spikes—for instance, the coronavirus appears—they experience sudden losses and they have to close out their positions quickly. What happens is the market becomes extraordinarily sensitive. And that’s why you get the kind of classic carry trade profile of long periods of calm, punctuated by very sharp drawdowns.
Carry traders are very vulnerable to volatility. And because these trades are levered, these traders only have the ability to withstand a modest amount of losses.
Your book title references “the dangerous consequences of volatility suppression.” What do you mean by that?
We didn’t have a Federal Reserve in the early 1900s. When market panics started, they either had to run their course or we had to rely on the private sector to organize bailouts. The Fed was created to deal with financial panics and provide liquidity in times of crisis. I think that’s what they saw themselves as doing in 2008 with quantitative easing. The unintended consequence is that it truncated losses for carry traders, and allowed some people who should have gone out of business to stay in business. It also encouraged more people to engage in carry trades.
The problem got bigger over time, and because the markets are much more sensitive to volatility, the Fed was forced to react to shorter-term market developments. In 2018, for instance, all the indicators of the economy were pretty strong, inflation was low, growth was pretty reasonable. But the markets had a bad fourth quarter and the Fed responded by cutting interest rates three times in 2019. It kept us going for another year. But it means that now it’s much more difficult to deal with the kind of global fallout of the coronavirus.
What we saw is that the Fed is exquisitely sensitive to short-term movements in the equity markets, and we think that’s because the economy as a whole is really exposed to volatility. Volatility goes up, the equity market goes down, the economy becomes very vulnerable and the Fed has to act. They have been suppressing volatility, so in some sense the Fed is starting to become captured by this carry process.
Are you saying that markets were more fragile than they appeared, before coronavirus hit?
That’s the conundrum of a carry trade. If you haven’t observed the steep losses, you look back at a history of steady gains and it looks safe. The economy has started evolving in the same way—since the financial crisis, you see steady, unspectacular growth. And so people think there’s not a lot of risk embedded in the system. Unfortunately, we don’t see the risk until the carry crash happens. One of the ideas in the book is that the path of economic growth is starting to look more like the path of carry trade profits: long periods of steady but not spectacular growth, punctuated by occasional steep recessions like 2008 and possibly now.
If you haven’t observed the steep losses, you look back at a history of steady gains and it looks safe.
The Econ 101 textbook says that the stock market essentially reflects the health of the real economy—if the real economy is growing, then the stock market is doing well. Our view is that causality is now flowing the other direction, that the economy is reacting to what’s going on in the stock market because there’s so much carry trading going on, and these carry trades are so unstable. Because of all that leverage it infects the economy, either directly or through companies that have high debt and are struggling to pay it.
How has carry trading contributed to the rise in inequality?
It has increased inequality because the people who are executing carry trades are typically already wealthy or are insiders with some political connections—company managers executing stock buybacks, or private equity firms or hedge fund managers. So when central banks intervene and suppress volatility to stabilize the economy, it has the effect of truncating losses and bailing out these people. People who should lose money don’t. It reinforces their wealth and encourages them to do it on a greater scale going forward. As this process takes place over time, it has the effect of reinforcing the existing advantage of carry traders who started out wealthy and get even wealthier.
What’s the antidote?
Countries that have managed the coronavirus pandemic most ably—Finland, Korea, Taiwan—had pre-arranged crisis protocols and emergency reserves. We need something similar for economic emergencies.
First, the most important recipients of government assistance should be those who lack cumulative advantage—workers and small business owners. Otherwise, each successive crisis just worsens inequality. Second, when big companies with critical operations—think airlines—are given assistance, it must involve caps on executive pay, restrictions on stock buybacks, government seats on boards, and requirements for building financial reserves. Third, the Fed needs to charge a market price for the insurance it provides. Carbon emissions have surged because there is no up-front cost for polluting. In the same way, debt and liquidity have surged in part because the Fed is acting as the world’s insurer of last resort, but not charging for it.
These changes will make it more expensive to borrow and less easy to trade. That’s really the point. A robust plan to deal with future pandemics will cost something now, but make us safer in the long-run. We need to have the same mindset as we try to reconfigure our markets to avoid the next carry crash.