Thursday, February 22, 2007

Return of serve

“We’re caught in a trap. We can’t walk out. Because I love you too much, baby.”

- Elvis Presley, Suspicious Minds

I hear ya, King.

Just when Macro Man thought he could write about fun stuff like Argentinean farmland or US railroad shares, Brad Setser over at RGE served up another piece on the global carry trade that (literally) invited a response.

Unfortunately, Macro Man has quite a busy day lined up today, so he cannot respond in as elegant a fashion as he might like. Instead, he offers a series of bullet point thoughts on the matter, alluding to points in Brad’s piece in italics.

Right now, I see lots of indirect evidence of the popularity of carry trades. Large Glacier bond issues and large -- perhaps record large -- foreign positions in the Icelandic Krona. A strong kiwi. Strong reserve growth (implying rapid capital inflows) in high carry emerging economies like Brazil, India and Turkey. The FT's concerns about slow Brazilian growth don't seem to be shared by the markets: Brazil could add close to $10b to its reserves in February alone trying to fight carry trade inflows. A weak yen and Swiss franc.

Macro Man does not dispute that there are some economic agents putting on carry trades. Hell, it would be churlish to do so, given that he has the carry trade on both in the blog and in real life. However, it is a probably a mistake to assume a 1:1 correlation with official reserve growth and ‘carry trades.’ After all, Chinese reserves are growing at a pretty healthy clip, and implied CNY rates in the NDF market are zero!

A significant (and, in Macro Man’s view, growing) source of capital inflows is in equity markets rather than fixed income. In Turkey, for example, many fixed income investors continue to buy T-bills, but at least partially currency hedge. Equity investors, on the other hand, almost always invest ‘naked.’ While an investment in Turkish equities can certainly be called a ‘risky’ trade, can it really be called a ‘carry’ trade? After all, the dividend yield of the ISE 100 is only 0.08% higher than that of the S&P 500 (and 0.23% lower than the S&P 100)!

The Vietnam Opportunity Fund provides an interesting glimpse into the rising interest in EM equities. Observe the massive uptick in volume over the past few months, which not coincidentally has accompanied both a strong rise in the underlying equities, but also in the dong (relatively speaking, of course.)

And of course, US investors have been enthusiastic about foreign equities like never before. Insert link to tic Again, these investments are certainly risky trades, but are they truly carry trades? (Whether the distinction matters economically is another question, given the correlations in global asset markets.)

* Are Japanese retail investors who buy – without borrowing any money – New Zealand bonds engaged in a carry trade? What of Japanese pension funds who buy US agency bonds for the yield pickup?

Yes, these are carry trades. But what about if Mrs. Kobayashi invests in a foreign equity investment trust, as she is doing with increasing volume? As above, Macro Man would characterize this as a risky trade, not a carry trade.

A more important question is whether Mrs. Kobayashi is establishing/adding to overweight risk positions, or covering underweight risk positions. The evidence is pretty firmly in favour of the latter. Even with the recent capital outflow from Japan, something like 50% of household financial assets are on deposit, a residue of the dark years when return of capital took precedence over return on capital. As has been widely discussed, those dark years appear to be behind us.

In Macro Man’s view, what we are seeing from the Japanese household sector is akin to what was observed among the institutional sector in the mid 1980’s: a one-off stock adjustment in the level of risky assets, including foreign assets, in investment portfolios. Given the large cash position of Japanese investors, Macro Man believes that we remain fairly early in this process.

* Personally, I suspect both the “real” money carry trade and the leveraged carry trade matter.

Agreed. But it is important to bear in mind that “real” people have a drastically different time horizon from investment professionals. But this includes not only people like Mrs. Kobayashi, who have a carry trade investment, but real money borrowers as well.

In Macro Man’s opening salvo on the carry trade a few weeks ago, he printed a chart of Japanese yen lending to foreigners. It is reprinted below. Even if we accept that none of the ‘investment’ carry trade is captured in this data, it still must ultimately represent lending to borrowers in the real economy: Koreans taking out yen mortgages, etc. And those who claim that the carry trade is much bigger than ever before must explain why the level of yen lending to foreigners has yet to approach, let alone exceed, levels observed 4-5 years ago.

Now, Macro Man will concede that CHF mortgages are a booming business, particularly in Eastern Europe. Yet despite the volatility of last spring, HUF has come back, and demand for Swiss mortgages is stronger than ever. Why? Because mortgage holders look at their statement once a month. It will take a sustained period of substantial HUF weakness/CHF strength to alter behaviour. Could it happen? Absolutely. Will it be a catalyst? Highly unlikely.

Brad then quotes Tim Lee of Pi Economics on a number of issues.

* The $1 trillion estimate comes originally from a piece of work I did, and I thought it only fair to contribute my explanation for anyone interested.

In the work I accept that guesstimates for the size of the carry trade that can be derived from balance of payments and banking statistics fall in the range US$100-350 billion...The one trillion number is less a genuine 'estimate' than an indication of what I believe to be the order of magnitude. My guess is that the outstanding carry trade is probably even larger than this.

To paraphrase a more colourful analogy: opinions are like tonsils. Lots of people have them, but that doesn’t mean they are of any use.

BOP data suggest a carry trade of 100-350 billion. Survey data of discretionary managers suggest very modest yen shorts (Russell Mellon, which shows a much larger dollar short) or yen neutrality (Merrill Lynch.) Macro Man doesn’t see sufficient evidence to balloon the carry trade estimate fivefold on the basis of a hunch.

* The big adverse development in the Japanese balance of payments data (IMF data) that occurred subsequent to the massive intervention up to March 2004 was the deterioration in 'monetary capital' (i.e. increase in Japanese banks' net foreign assets). This suggests that it is carry trades that have weakened the yen, not Japanese institutional or retail funds going into foreign securities, and it suggests that the moral hazard created by the intervention was the original cause.

The massive inflow into Japan in late 2003 /early 2004 was a partially a result of speculative inflows, but more substantially a product of the daiko henjo, by which Japanese pension funds returned money to the government for management, selling foreign securities and returning the cash to the government. Part of the Japanese demand for foreign assets of the past few years has been the redeployment of that investment capital abroad.

* Indications of the carry trade such as Japanese banks' gross foreign assets, cumulative short-term net foreign lending from the Japanese bop, the spec net short position on the Chicago IMM correlate quite well with each other and also with the yen rate. I think these indicators do not tell us the size of the carry trade but they do tell us the direction. Again, these suggest that it is the carry trade that has been responsible for yen weakness.

The IMM is almost exclusively used by trend followers. They don’t care what the BOJ does, what the Fed does, or what phase of the moon we are in. They amplify price action; they do not create it. If the IMM yen position does represent a yen carry trade, it begs the question of why IMM traders are short yen against a basket of EUR and GBP, rather than simply against the dollar.

* Carry trade currency relationships are now enormously out of line with fair values. I have the yen about 30% undervalued against the dollar. The Turkish lira I have 130% overvalued against the yen, which is extraordinary. Turkish inflation is 10%, but the lira simply will not go down (bar the episode last spring).

Mr Lee has the yen 30% undervalued against the dollar. Macro Man has the yen 7.5% undervalued against the dollar. In a world driven by capital account rather than current account flows, it is not immediately apparent how or why either estimate matters. And if Mr. Lee is correct, why isn’t the US bilateral deficit with Japan substantially larger? Since 1985, US exports to Japan have grown 268%, while imports have grown 217%. This hardly suggests a drastically overvalued exchange rate, particularly when one considers that US nominal GDP has tripled in size over the period, while Japan’s is just 50% larger.

* The Japanese MOF/BOJ had to acquire roughly US$500 billion to prevent the yen appreciating up to March 2004. The yen is now much lower in real terms. Logically the amount of intervention next time round is going to have to be much greater - my estimate is roughly US$2 trillion. The idea that the carry trade is, say, only US$200 billion is inconsistent with this in my view

Macro Man does not understand the logic here at all.

* When you add all this together, it is simply not plausible, in my view, that the carry trade could be as small as most observers are saying. The observed impact that the carry trade is having on the currency and other markets is too great. As to why hedge funds, investment banks and others have not been frightened out of it, I think they have 'learned' that it 'always works' in the end, much as technology growth stock investors 'learned' in the second half of the 1990s. They do not see how it could possibly go badly wrong until Japanese rates have been raised significantly, and they see no prospect of that.

Macro Man believes the real issue is that many analysts have not realized that the universe is expanding. The home bias in Japan and, to a lesser degree, the US, has come down, meaning that what was a large holding of foreign assets in 1997 might be considered woefully tiny in 2007. This is a trend that is both well entrenched and in its early stages. There is of course no guarantee that money will not be repatriated from time to time; if and when this occurs, EM equities and bonds are likely to be the biggest losers.

In a sense, Macro Man feels like Edwin Hubble in realizing the extent of the expanding universe. There were plenty of smart guys, including Albert Einstein, who were slow to recognize that the universe is expanding. Similarly, there are plenty of smart people, both analysts and fund managers, who have yet to recognize the significance of the expanding investment universe.

Macro Man will close with an interesting anecdote: Over the past few days he has spoken with a number of sell-side institutions. A common theme is the degree of surprise is how many long yen positions are out there from discretionary managers; these positions are revealed when the fund managers roll their forwards.

There seems to be a common misconception that currency traders and macro managers are either blind, stupid, or na├»ve. While most of us are all of these things on occasion, natural selection ensures that we can’t be that way all the time. We can see as clearly as the economists that things like EUR/JPY are farcically overvalued. That’s why many discretionary traders have attempted to play the yen from the long side.

But Mrs. Kobayashi is a force of nature, and she is still gathering strength. The only agency capable of stopping her is Voldemort, but for the time being he seems content to be the biggest carry trader of them all.



Anonymous said...

At 50bp's , it will take 139 years to double your money ...

I wonder what the econ gurus think investors in Japan should do

Anonymous said...

Bring in Larry the Liquidator, churn up the corporate market, and tell young people to quit text-messaging and get to work. I just bought some more J equities on the long bet, no FX hedge.

Macro Man said...

I thought Larry was too busy shutting down all the subprime lenders in the US...

Anonymous said...

Larry is busy, and Larry doesn't like to lose. "A good loser is a sure loser." I hated Larry on principal as an inhuman greedhead years ago. But when I learn about the corrupt zombie loans by Japanese banks keeping inefficient companies afloat, and management who spit on their Japanese shareholders, I want Larry to get to work. With a little left over for me.

Macro Man said...

Ah, but the problem is that there is a huge bouncer at the door called Abe-san, and he doesn't like the look of Larry. Larry's gotta figure out how to get through the door before he can hit the dancefloor. In the meantime, the bouncer prefers deadweight in short skirts and stilettos...

Anonymous said...

macro man -- any chance you could increase the font size on your graphs? I am having a hard time reading the scale on the x axis (which would help me line up the moves in yen loans outstanding with other things that were going on in the world).

sorry tho for bringing the conversation down a notch. talking about larry the liquidator, and short skirts and stilettos is a bit more fun ...

brad setser

Macro Man said...


If you click on the chart, it should maximize itself so you can see it in all its 'glory'.



ilanit said...

In September I would have speculated that MS would not be treating a first-tier Orange County equity investment like Blackstone this way. But as the Fall has progressed and the potential liability increased it is clear that banks are willing to risk even their largest clients to wriggle away from some of these deals.