The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (BUSINESS BOOKS)

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Jamie Lee works for investment guru and philanthropist Jeremy Grantham, focusing on environmental research and volatility trading. He previously worked as economist and analyst for asset management companies in Boston and London. Jamie holds a B.A. in Mathematics and English from Dartmouth College. money-printing presses went into overdrive. A myriad of emergency funding windows were opened to enable cash to be injected into the financial system, and from virtually any and all directions. Sovereign borrowing and credit guarantees were issued left, right, and center. Direct public funding was placed into all the major American banks and many of the smaller ones” This, “unprecedented deployment of liquidity and direct involvement in markets played a critical role in reconnecting the wires of the market system and restoring trust (p. 48, El-Erian) In this world, with the dominance of the Fed and the dollar, and the liquidity of the S&P 500 derivatives markets, the S&P 500 has evolved to become itself a carry trade at the centre of the global carry regime. A sudden crash in the S&P 500 crashes the global economy. The Fed then reacts by becoming a giant carry trader itself, replacing the private sector carry trade and ultimately reinforcing the carry regime. Of course, “solvent but illiquid” is exactly the situation SVB was said to be in. Expect to hear this messaging a lot more in the coming years. The line between market support and QE will become increasingly blurry and, as it does, the risk of much higher inflation will increase.

In this book we define all carry trades to share certain critical features : leverage, liquidity provision, short exposure to volatility, and a “sawtooth” return pattern of small, steady profits punctuated by occasional large losses (p. 3, LL&C). Protect yourself from the next financial meltdown with this game-changing primer on financial markets, the economy--and the meteoric rise of carry.

Financial instability has thus risen as the carry trade has grown. The Rise of Carry does not estimate the size of the market, for which reliable data do not seem to be available, but the authors argue convincingly that it is very large and has expanded greatly in recent years. They also point to the risk that volatility in different financial assets may be contagious: “There is also evidence of a growing correlation between currency and equity market carry, suggesting that a single global volatility risk factor may be a driver of all forms of carry in the future. If this is true, future carry crashes may impact on all asset classes at the same time.” 7 But the intuition behind the indicator is that what matters is the present rate of money growth…I think it would be hard to get an inflationary result out of the present conjunction of any possible relevant variables.” He is a co-author of The Rise of Carry (2020). He is also the author of the highly regarded Economics for Professional Investors (2nd edition 1998) along with many articles in newspapers and journals. His commentaries and analyses have been widely quoted.

Traders do not especially care their strategies affect the operation of the market more generally, but the authors do explore this interesting facet of the carry story. I particular enjoyed their description of selling vol at short durations, then buying it at long durations. This nicely fits certain stylised facts of market behaviour: mean reversion at shorter horizons, and momentum at longer horizons.It is for example a matter of dispute whether derivatives increase or decrease the volatility of their underlying financial assets. Some hold that speculation is generally stabilizing; and since it has become easier with the rise of derivative trading, asset markets should have become less volatile. Holding a short position in volatility, by contrast, produces steady profits at the expense of occasional large losses. In the event of higher volatility, those who provide insurance against such an increase have a high risk of going bankrupt—a risk that is amplified if, as seems most often to be the case, they are leveraged. Thus a rise in volatility has the potential to set off a vicious cycle: when volatility rises, the cost of insuring against both gamma and vega risks will likewise rise; as a result of this increased cost, the market will become less liquid, and the decline in liquidity is itself likely to enhance volatility. The past few decades have been too prosperous in Western countries. The book's authors believe that, sooner or later, people will have to pay for that with a painful long-term economic recession. They also predict that eventually, central banks will lose their ability to influence the situation. After that, the financial system will transform somehow.

Interestingly, this expectation of ample liquidity runs counter to what has actually transpired when consensus views have changed and investors have sought to reposition their portfolios accordingly. In May–June 2013, when Chairman Bernanke uttered that famous word — “taper” — and raised questions about the Fed’s continuous support for markets, many investors were unable to complete their desired transactions for even the most vanilla-type securities (p. 115, El-Erian) Because there exists an risk-of-ruin, and the manifestation of which on a large scale in unacceptable to the central bank: Simply put, carry trading is now the primary determinant of the global business cycle--a pattern of long, steady but unspectacular expansions punctuated by catastrophic crises.carry traders are often forced to close positions when prices move against them. This necessarily means selling assets that are falling in price (or buying assets that are rising in price). Thus, the dynamics of managing carry trade risks create fire-sale effects in which initial movements in prices are often substantially amplified. The expansion of carry trades always increases liquidity; the reduction or closing of carry trades leads to liquidity contraction (p. 3, LL&C). The book only briefly mentions the accumulation of moral hazard. However, in my opinion, this is where the main problem lies. In the institutions that run the society, the proportion of idiots has been steadily increasing for many decades. It is now close to 100%.

The central thesis of the book is as follows. The financial authorities of developed countries artificially suppress volatility in financial markets. In the past few decades, selling volatility has been too profitable. The buyers of put option made significant profits in those rare periods when the bubbles collapsed. However, even despite it, buying volatility has been too unprofitable. In 2002, he moved to California to co-found Algert Coldiron Investors, a quantitative equity specialist managing both hedge funds and long-only strategies. ACI was consistently ranked by alternative investment consultants as among the best equity market neutral managers globally. Because volatility risk cannot be hedged in aggregate and the total amount insured seems to have grown so much, there is broad agree­ment that a future increase in volatility will produce big winners and big losers. There is, however, no consensus on whether this will simply involve a large-scale exchange of wealth between otherwise equivalent players in the market—the Pauls receiving large sums from the Peters—or if it will have serious economic, political, or social consequences.

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Over at least the past 30 years financial markets have become increasingly dominated by carry trades; markets can be said to be in a ‘carry regime’. Carry trades have in common four features: 1) Leverage; 2) They provide liquidity to markets; 3) Short volatility exposure; and 4) a ‘saw tooth’ return pattern. Particularly because of the liquidity provision feature, carry trades have always had a role in the financial system. But certain non-market developments, particularly the increasingly dominant role of the Federal Reserve and other central banks, have led to the evolution of the carry regime. This relationship is difficult to show graphically, as there are over twenty-three thousand data points for each data series. The financial shelves are filled with books that explain how popular carry trading has become in recent years. But none has revealed just how significant a role it plays in the global economy - until now. The ways that carry, volatility selling, leverage, liquidity, and profitability affect the business cycle Some might argue that the indicator is mis-specified because we have been coming off a huge jump in money supply and therefore there could still be an excess of money, in some sense.