Notes - The Rise of Carry

October 10, 2024

Chapter 1 Introduction—The Nature of Carry

The rise of carry, or the suppression of financial volatility, is the root cause of major market events over the past 25 years. This includes stock market fluctuations, the growth of the US stock market despite mediocre economic performance, companies buying back their own shares, investors' focus on central bankers' statements, and the rise of populist movements. The growth of carry is fundamentally linked to a society's power structure and central banks act as agents of this power structure.

All carry trades, regardless of the asset class, share these critical features:

• Leverage: Carry trades either explicitly use borrowed funds or utilize contracts that create a potential loss greater than the initial capital. This heightened risk sensitivity forces traders to close positions during price movements, leading to fire sales that amplify price changes.
• Liquidity provision: Carry trades exploit price discrepancies that arise from liquidity differences between markets. They provide liquidity and credit to the real economy.
• Short exposure to volatility: Carry trades are essentially bets against market volatility. Volatility spikes, however, lead to significant losses, as experienced during the 2008 crisis.
• Sawtooth return pattern: Carry trades yield small, steady profits punctuated by large losses during market downturns.

Central banks, as lenders of last resort, underwrite some of the losses associated with carry, which encourages further growth of carry and creates a self-reinforcing cycle. This leads to:

• Success in financial markets becoming more about insider status than competence.
• Reinforcement of wealth inequality by protecting wealthy investors from the full consequences of carry crashes.
• A blurred line between economic recessions and financial market downturns, with recessions becoming a function of asset price declines.

In the current economic system, carry, volatility selling, leverage, profits, liquidity, and power are closely related. The system's development favors access to power over talent or merit when determining an individual or entity's wealth. Understanding the implications of carry is crucial for comprehending the future of finance and macroeconomics.

Chapter 2 Currency Carry Trades and Their Role in the Global Economy

Currency carry trades, the most widely understood form of carry, involve borrowing in a low-interest-rate currency and investing in a high-interest-rate currency. The trader earns the difference between the interest rates, or the "interest rate spread".

Key aspects of currency carry trades include:

• Disregard for Currency Risk: This drives the demand for credit, potentially leading to unsustainable investment projects.
• Covered Interest Rate Parity Failure: After the 2008 crisis, borrowing dollars through foreign exchange swaps became more expensive than interbank borrowing, suggesting constraints on banks' balance sheets and the growing influence of carry trades.
• The Yen Carry Trade and the Global Credit Bubble: The substantial growth of the yen-funded carry trade coincided with the buildup to the 2007–2009 crisis. Its unwinding played a significant but often overlooked role in the subsequent global meltdown.

Chapter 3 Carry, Leverage, and Credit

Carry trades are inherently levered. This is illustrated by examples such as:

• Insurance contracts where the insurer receives small premiums until a catastrophic event leads to a major payout.
• The mortgage bubble before the 2008 crisis, which involved financing high-risk mortgages with low-cost funds. The development of credit derivatives, like collateralized debt obligations, masked the true risk involved in these carry trades.

Australia serves as a prime example of the impact of carry capital flows, experiencing substantial inflows correlated with global carry trade cycles.

Key takeaways regarding carry trades include:

• Their risky nature and skewed return patterns, characterized by small gains and occasional large losses during financial stress.
• Central bank interventions, while stabilizing, create moral hazard and encourage carry trade growth.
• Carry's growing influence as the main driver of the global credit cycle and a key risk factor for financial market stability.

Understanding the history of currency carry trades is crucial for anticipating the risks associated with future financial crises.

Chapter 4 Dimensions of Carry and Its Profitability as an Investment Strategy

Analyzing the history of currency carry returns helps understand their characteristics. A backtest of a hypothetical currency carry portfolio, built using realistic rules, reveals the following:

• High Information Ratio (IR) but Low Absolute Returns: While the risk-return trade-off appears favorable, the strategy's absolute returns are low, requiring substantial leverage (e.g., 1,000% or $5 short and $5 long for every $1 of capital) to achieve returns comparable to assets like the S&P 500.
• Inclusion of Emerging Market Currencies: While emerging market currencies can offer higher yields, their depreciation against developed currencies during crises can negate their benefits.
• Losses during Financial Crises: The growth of carry trades across asset classes means losses will be large and occur during unfavorable market conditions, as seen during the 2008 crisis.
• Correlation with Volatility: Carry trade returns show a strong negative correlation with volatility, particularly the VIX (a measure of implied volatility for the S&P 500). This suggests a growing link between currency and equity market carry, potentially leading to simultaneous carry unwinds across asset classes.
• Consistency with BIS Data: The portfolio's positions align with BIS data, indicating countries like Australia, Brazil, and China as major recipients of carry trade flows.

Key insights from the currency carry strategy backtest include:

• Need for substantial leverage, which increases risk and the potential for losses.
• Drawdown dynamics, where modest changes in position value can lead to a total loss of capital. This risk control dynamic can create a "bank-run" effect, amplifying price movements.
• The skewed return pattern of small gains and occasional large losses, often coinciding with negative market events.
• The growing correlation between currency and equity market carry, suggesting a single global volatility risk factor driving all forms of carry. This implies potential simultaneous carry crashes across all asset classes in the future.

Chapter 5 The Agents of Carry

The pervasiveness of carry in financial markets is linked to the growth of institutions incentivized to engage in carry trades. These "agents of carry" are identified by:

• The nature of their liabilities: Institutions with liabilities that do not require them to sell assets during market downturns are more likely to engage in carry.
• The structure of their compensation: Institutions that reward short-term profits and don't penalize subsequent losses encourage carry-seeking behavior.
• The amount of leverage they employ: Leverage amplifies returns, making carry strategies more attractive to institutions able to utilize it.

Based on these criteria, the following institutions are identified as potential agents of carry:

• Hedge funds: Despite their long-term investment horizon, their compensation model (profit share) and use of leverage incentivize them to pursue carry strategies.
• Sovereign wealth funds: These funds, with long-term liabilities and strong balance sheets, are well-suited for carry strategies, particularly in foreign exchange. They also have the capacity to use leverage to enhance returns.
• Global investment banks (pre-Volcker Rule): The compensation structure of investment banks, heavily reliant on annual bonuses tied to profits, encouraged carry-like trading exposures.
• Private equity funds: These funds engage in a form of carry trade by using borrowed money to buy companies with earnings yields exceeding the cost of debt. While the focus is on capital gains rather than consistent yields, the strategy relies on a levered yield spread.
• Corporations: Evidence suggests that non-financial corporations increasingly engage in carry trades. They borrow at low interest rates, often in US dollars, to finance higher-yielding investments, such as buying back their own equity.

The rise of high-frequency trading firms (HFTs), which essentially provide market liquidity, can also be linked to the growth of carry, particularly in the US equity markets. Ultimately, central banks are the most influential agents of carry, with their large balance sheets effectively representing a giant carry trade.

Chapter 6 The Fundamental Nature of the Carry Regime

Carry trading, to some extent, is beneficial as it provides liquidity and leverage to markets. Carry traders are compensated for this service and the risk they bear during market downturns. However, the growth of carry, particularly volatility selling in the S&P 500, has significant implications for global markets.

The US market, specifically the S&P 500, has become the epicenter of global carry trading due to:

• The depth and liquidity of its derivatives and ETF markets.
• Its strong correlation with other equity risk trades.
• Its position as the world's most important benchmark, making it a primary hedging instrument for less liquid assets.

This centrality makes the S&P 500 itself the ultimate carry trade, with S&P 500 volatility, as measured by the VIX, emerging as the central risk factor in global markets.

While seemingly benign, the dominance of carry trading raises concerns. Its growth, particularly through currency carry trades, may signify a mispricing of risk and a misallocation of resources, largely attributed to central bank policies. The close relationship between the S&P 500 and currency carry trades, as indicated by data, suggests a convergence towards a "market of one", where both strategies tend to perform similarly.

Understanding why selling VIX futures, a direct way to sell volatility, is profitable and prone to severe drawdowns is key. Figure 6.3 illustrates this trend. The answer lies in the concept of volatility, optionality, and leverage.

Volatility represents the cost of optionality, which is implicit in dynamic investment strategies, such as maintaining constant leverage. The need to adjust positions to maintain constant leverage in response to market fluctuations creates trading costs, which are higher when volatility is greater.

Selling optionality, or trading against the market, is inherently risky and typically earns a premium. This is because the trader continually increases losing positions, buying as prices fall and selling as they rise. However, if the price eventually reverts to its starting point, the trader can profit from buying low and selling high during fluctuations. This strategy is essentially "buying the dip," which has proven profitable in the current market environment.

The growing use of leverage in the financial system has led to an increased demand for liquidity, making volatility trading crucial. The S&P 500, with its deep and liquid markets, attracts volatility trading, making the VIX the primary indicator of global volatility and the price of optionality across markets.

Carry crashes are a consequence of the inherent leverage in carry trades. When leverage is high, even small market movements can lead to significant losses, forcing traders to reduce positions and further amplifying price declines. This "bank-run" dynamic is central to understanding carry crashes.

The centrality of the S&P 500 to the global carry regime makes it a crucial indicator of global risk. As the world's primary hedging instrument, providing liquidity to the S&P 500 offers a significant premium to volatility sellers. This premium is reflected in the structure of volatility for the S&P 500, where implied volatilities consistently exceed realized volatilities, making various volatility-selling strategies profitable.

However, central bank interventions, particularly through quantitative easing, distort this natural pricing of volatility. Central banks essentially engage in a giant carry trade by buying higher-yielding assets and financing them with their own low-yielding liabilities. This intervention creates a moral hazard, encouraging excessive risk-taking and amplifying carry bubbles and crashes.

The chart in Figure 6.5 demonstrates the close relationship between the Fed's holdings of long-duration securities and the S&P 500, highlighting the Fed's direct contribution to the expansion of carry trading. While often attributed to money pumping, the surge in the S&P 500 following quantitative easing can be better explained by the Fed's suppression of volatility and its role as a massive provider of capital to the carry trade.

This central bank intervention distorts the natural carry cycle, creating a series of increasingly larger carry bubbles and busts, rather than an equilibrium process driven by the need for liquidity.

Chapter 7 The Monetary Ramifications of the Carry Regime

The carry regime, while fundamentally deflationary due to its reliance on high debt levels, creates a perception of high liquidity and rising asset prices during its bubble phases. This is achieved through leverage, volatility suppression, and the extension of moneyness to non-monetary assets, primarily debt instruments.

The carry regime creates a perception of reduced credit risk, leading to:

• Prolonged existence of unprofitable investments.
• Excessive consumption relative to investment, fueled by artificially low interest rates on consumer debt.
• A decline in productivity as non-viable firms are kept afloat by bank forbearance and prolonged monetary stimulus.

Figure 7.4 illustrates this trend.

The perception of what constitutes a monetary asset expands during carry bubbles as central bank interventions make a broader range of assets seem money-like. This effective increase in the money supply masks the underlying deflationary forces and can even create inflationary pressures. The carry regime can be seen as a market mechanism that temporarily stabilizes an inherently unstable fiat money system.

However, carry crashes expose the illusion of liquidity and reveal the underlying deflationary pressures. As volatility spikes, the value of money rises, and previously money-like financial assets lose their perceived safety. This leads to a surge in the demand for actual money, potentially causing rapid deflation unless central banks can rapidly expand the money supply.

Chapter 8 Carry, Financial Bubbles, and the Business Cycle

Understanding the economy through the lens of carry requires a shift from conventional economic models. The carry regime alters the traditional understanding of the business cycle:

• Economic expansions are driven by consumption and speculation, fueled by carry trades, rather than productive investment.
• Economic contractions are sudden and violent, marked by carry crashes, rather than gradual downturns.

The dominance of carry creates disguised carry bubbles that are difficult to recognize using traditional metrics:

• Conventional valuation measures become distorted, as factors like corporate profits are themselves inflated by the carry bubble.
• Focus on traditional measures like price/earnings ratios can obscure the true extent of the bubble.

The carry regime inherently involves mispricing of risk. While investors may recognize the true risks, the potential for government bailouts distorts risk assessment, leading to lower yields than justified by the underlying fundamentals.

The carry regime disguises the nature of economic growth. While seemingly robust during the bubble phase, the growth is driven by increased consumption and a pull-forward of future demand, rather than sustainable investment. The carry crash exposes the unsustainable nature of this growth and leads to a sharp economic contraction.

The example of the oil market illustrates how carry trades can initially provide liquidity and facilitate hedging but can also contribute to the mispricing of risk and the formation of unsustainable bubbles. This mispricing can lead to excessive investment in high-cost production and a delayed adjustment to true market conditions.

The carry regime's progression through successive bubbles and crashes, each larger than the last, is characterized by the increasing involvement of different economic sectors. The 2007-2009 crisis was primarily driven by the banking sector. However, the subsequent bubble, fueled by central bank interventions, involved the corporate sector and shadow banks, taking advantage of low interest rates to engage in carry-like activities.

The carry regime's impact on profit share and wealth accumulation further underscores its distortionary effects. The rising profit share despite declining economic growth suggests that corporate profits are being artificially inflated by carry trade activities. Similarly, the growth of personal net worth relative to GDP highlights the speculative nature of wealth creation under the carry regime.

Chapter 9 The Foundation of Carry in the Structure of Volatility

Understanding the structure of volatility is crucial for comprehending the carry regime. This chapter explores the dynamics of volatility, optionality, and leverage, providing insights into how carry trades are inherently linked to volatility selling and liquidity provision.

The concept of replicating option payoffs through trading strategies illustrates the relationship between volatility and optionality. Replicating a call option requires trading with the market, buying when the price rises and selling when it falls. This strategy, equivalent to buying optionality, incurs trading costs that are proportional to the asset's volatility. Conversely, selling optionality, or trading against the market, involves selling as the price rises and buying as it falls, a strategy inherently risky but potentially profitable if prices mean revert.

The historical tendency for implied volatilities to exceed realized volatilities creates a premium for selling volatility. This premium is evident in various strategies:

• Selling options delta-hedged: This involves selling options and hedging the position by trading the underlying asset, profiting from the difference between implied and realized volatility.
• Shorting volatility futures: Directly betting on the decline of implied volatility.
• Exploiting mean reversion: Buying when the market dips and selling when it rallies, effectively replicating short optionality. This strategy benefits from the tendency for large short-term market moves to partially reverse over longer periods.

These volatility-selling strategies essentially provide liquidity to the market. Dip buyers, for example, offer liquidity to those forced to sell during market declines, earning a premium for their willingness to absorb risk.

The structure of volatility premiums in the US stock market reflects the dominance of carry trading. Figure 9.4 illustrates this structure, demonstrating that implied volatilities are higher for longer maturities, realized volatilities are higher for shorter time horizons, and implied volatilities consistently exceed realized volatilities.

This structure creates a profitable environment for volatility sellers, who effectively act as liquidity providers. They earn premiums by exploiting the various discrepancies between implied and realized volatilities, providing liquidity across different time horizons and smoothing out market fluctuations.

The depth and liquidity of the S&P 500 market make it the primary destination for global risk transfer. The S&P 500's role as the world's premier hedging instrument implies that providing liquidity to this market commands a substantial premium. This is reflected in the structure of volatility for the S&P 500, where volatility sellers consistently earn a significant risk premium.

The carry regime distorts the natural relationship between risk and return, leading to a buildup of systemic leverage and a potential for severe carry crashes. The more leveraged the system, the greater the demand for liquidity and the higher the premium for selling volatility. Central bank interventions, acting as giant volatility sellers, exacerbate this distortion and contribute to the formation of increasingly larger carry bubbles and crashes.

Chapter 10 Does the Carry Regime Have to Exist?

The carry regime, characterized by a positive price for liquidity and a skewed return profile for carry trades, has become a defining feature of financial markets, particularly the S&P 500. The question arises: is this regime inevitable, or can we envision a world without it?

Analyzing the structure of volatility offers insights into the nature of the carry regime. The positive price for liquidity manifests in the following ways:

• Shorter-term realized volatilities exceed longer-term realized volatilities.
• Further forward implied volatilities exceed nearer forward implied volatilities.
• All implied volatilities exceed all realized volatilities.

This structure implies that strategies providing liquidity (trading against the market) are consistently profitable, while strategies taking liquidity (trading with the market) are consistently costly.

The persistence of this pattern suggests that liquidity short squeezes, sudden and catastrophic events where liquidity disappears, are an inherent feature of the carry regime. These squeezes occur against the underlying risk premium, leading to losses for those receiving the premium. In equity markets, these squeezes typically manifest as sharp market declines, contributing to the skew observed in both implied and realized volatility.

The chapter explores hypothetical scenarios to challenge the inevitability of the carry regime. These thought experiments, illustrated by Figures 10.1 and 10.3, explore alternative volatility structures that would disincentivize carry trades and potentially lead to an anti-carry regime characterized by persistent inflation and a reversal of traditional volatility relationships.

While these scenarios are highly speculative, they highlight the crucial role of deflationary pressures and central bank policies in shaping the current carry regime. The thought experiment suggests that an inflationary world would necessitate a fundamental shift in market dynamics and investor behavior, potentially ending the dominance of carry.

Chapter 11 Carry Is Synonymous with Power

The chapter explores the fundamental origin of carry, arguing that it is a manifestation of cumulative advantage, the tendency for initial advantages to compound and create self-perpetuating cycles of success. This principle applies across various domains, from social hierarchies to financial markets.

Examples of cumulative advantage include:

• The Matthew Effect: Success breeds further success, as those who have achieved recognition and resources are more likely to attract further opportunities.
• Social Proof: People tend to follow the lead of others, creating a snowball effect where popular choices become even more popular.
• Network Effects: The value of a product or service increases as more people use it, creating a barrier to entry for competitors.

Carry trades, by exploiting liquidity differences and leveraging gains, embody the principle of cumulative advantage. Those with access to capital and liquidity can amplify their returns and further consolidate their position in the market, creating a self-reinforcing cycle of wealth accumulation.

Cumulative advantage is evident in various aspects of financial markets:

• Currency Carry Trades: Those borrowing in low-interest-rate currencies and investing in high-interest-rate currencies benefit from the carry trade's tendency to reinforce existing currency strength and weakness.
• Volatility Selling: Liquidity providers, by selling volatility and earning premiums, contribute to the suppression of market fluctuations, further encouraging leverage and risk-taking.
• The S&P 500's Dominance: The S&P 500, due to its liquidity and depth, has attracted a disproportionate share of global capital, reinforcing its position as the central hub for risk transfer and volatility trading.

The carry regime, by amplifying cumulative advantage effects, can distort market outcomes and exacerbate inequality. This raises concerns about the fairness and efficiency of resource allocation in a system where initial advantages are systematically reinforced.

However, cumulative advantage is not inherently negative. It plays a crucial role in various biological and social processes, driving innovation, adaptation, and the emergence of complex systems. From the evolution of life to the formation of social hierarchies, cumulative advantage is a fundamental force shaping the world around us.

Chapter 12 The Globalization of Carry

The carry regime, driven by the pursuit of low-volatility returns and fueled by central bank policies, has extended its reach globally, creating a complex web of interconnected financial flows and amplifying systemic risks. This globalization has been facilitated by:

• Cooperation between governments and multilateral agencies.
• Coordination between central banks, particularly through liquidity swaps.
• The growth of the currency carry trade, which channels capital from low-interest-rate to high-interest-rate countries.

The globalization of moral hazard is a key consequence of the carry regime's expansion. Central bank interventions, aimed at stabilizing markets and providing liquidity, create an implicit safety net for investors, encouraging excessive risk-taking and fueling carry bubbles. This moral hazard is not confined to individual countries but extends globally, as central banks coordinate their actions and provide mutual support during crises.

Liquidity swaps, agreements between central banks to exchange currencies, play a crucial role in the globalization of carry. These swaps enable central banks to provide dollar funding to banks and corporations in other countries during periods of stress, preventing forced liquidations and mitigating carry crashes. However, these interventions also reinforce moral hazard and mask the true risks associated with carry trades.

The carry regime's globalization creates a convergence towards a "market of one", where the S&P 500, due to its liquidity and centrality, becomes the ultimate destination for global carry trades. This convergence amplifies the S&P 500's importance as a bellwether for global market sentiment and increases its vulnerability to carry crashes.

While the US market enjoys a degree of resilience due to the dollar's reserve currency status, the carry regime creates vulnerabilities in other countries, particularly emerging economies. These vulnerabilities manifest as economic imbalances, distorted financial structures, and a reliance on external funding, making them susceptible to sudden capital outflows and carry crashes.

The carry regime's influence extends beyond economics, shaping the intellectual and cultural landscape. The pursuit of low-volatility returns and the expectation of central bank interventions influence investment strategies, risk management practices, and even the perception of risk itself. This intellectual adaptation to the carry regime further reinforces its dominance and makes it difficult to challenge its underlying assumptions.

The globalization of carry creates a self-perpetuating cycle. Investors, incentivized by low-volatility returns and the expectation of central bank support, pour capital into carry trades, fueling asset price bubbles and expanding leverage. Central banks, responding to market pressures and the risk of systemic instability, intervene to provide liquidity and mitigate crashes, further reinforcing moral hazard and encouraging carry-seeking behavior.

Chapter 13 Beyond the Vanishing Point

The carry regime, characterized by the suppression of volatility, the pursuit of low-volatility returns, and the reliance on central bank interventions, has profoundly altered the functioning of financial markets and the global economy. This chapter explores the potential consequences of this regime's continued dominance, highlighting the risks and uncertainties associated with its eventual unwinding.

The carry regime has led to a convergence of economic growth and interest rates towards zero, a phenomenon termed the "vanishing point". This convergence reflects the carry trade's tendency to suppress volatility, reduce risk premiums, and create a perception of abundant liquidity, even as underlying economic growth stagnates.

Central bank policies, while initially intended to stabilize markets and promote economic growth, have inadvertently contributed to the carry regime's dominance. By lowering interest rates, providing bailouts, and engaging in quantitative easing, central banks have created a moral hazard that encourages excessive risk-taking and fuels carry bubbles. This has led to a distorted perception of risk, where investors underestimate the potential for losses and rely on central banks to intervene as a backstop.

The carry regime's reliance on central bank interventions raises concerns about its long-term sustainability. As carry trades expand and leverage increases, the potential for systemic risk grows, posing challenges for central banks' ability to effectively manage market volatility and prevent financial crises.

The chapter explores potential scenarios for the carry regime's unwinding, highlighting the possibility of:

• Systemic collapse, which could undermine the dominant role of central banks and lead to a restructuring of the global financial system.
• Galloping inflation, which would erode the value of debt and undermine the carry trade's profitability.

Distinguishing between a severe carry crash and the absolute end of the carry regime is crucial. The 2008 financial crisis, while a significant event, ultimately led to a further strengthening of the carry regime, as central banks intervened aggressively to stabilize markets and restore confidence. The true end of the carry regime would likely require a more fundamental shift in market dynamics and investor behavior, potentially driven by a loss of faith in central bank policies or a sustained period of inflation.

The concept of an "anti-carry" regime, characterized by high inflation and a reversal of traditional volatility relationships, is explored as a potential alternative to the current regime. While speculative, this scenario highlights the possibility of a fundamental shift in market dynamics, where carry trades become unprofitable and investors seek to hedge against inflation rather than volatility.

The carry regime's implications for wealth inequality are discussed in the context of Thomas Piketty's work. Piketty's data suggest that capitalism, in its current form, tends towards increasing wealth concentration. The carry regime, by favoring those with access to capital and liquidity, exacerbates this trend and reinforces existing power structures.

The chapter concludes by emphasizing the need for a reassessment of monetary policy and a shift away from the carry-driven model. Central banks, instead of fueling carry trades and creating moral hazard, should focus on promoting sustainable economic growth and ensuring long-term financial stability.

The authors acknowledge that carry is a natural phenomenon and that carry trades, to some extent, provide valuable liquidity to markets. However, they argue that central bank interventions have distorted the natural functioning of carry, creating a system prone to excessive risk-taking, asset bubbles, and recurrent crises. A more sustainable approach requires a recognition of the carry regime's pervasive influence and a commitment to policies that prioritize long-term economic health over short-term market stability.