Most people assume that economic and financial market recovery will be based on coronavirus cases peaking. Unfortunately, it is much more complicated than that. The crash in global financial markets would have happened anyway at some point, even without the virus. There were clear signs that it was coming. These included stresses in the US repo market that emerged in September and the decline in real and nominal interest rates, which implied that underlying global economic growth was already weakening.
The financial crash is what Jamie Lee, Kevin Coldiron and I, in our book The Rise of Carry, call a “carry crash”. A carry crash is not merely a big stockmarket decline but an almost straight-down crash in stockmarkets and credit markets, together with an evaporation of liquidity across all financial markets and a surge in the major funding currency for global leverage (the US dollar). All of these features were clear in the recent crash – as they were in the 2008 crash.
The pin that burst the bubble
A pattern of returns from an investment or financial position featuring long periods of steady gains interspersed with dramatic crashes is typical of the pattern of returns from carry trades. Carry trades can be thought of as trades that make money when “nothing happens”: when financial volatility is low or falls lower. Levered yield-seeking trades in financial instruments or currencies are carry trades, as are insurance policies and buy-to-let property investments. If nothing goes wrong they make money steadily. If a “bad event” happens or financial volatility rises sharply, losses come in a rush. This time, the bad event was the coronavirus.
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The fact that global financial markets as a whole, and even the economy, have been displaying a carry trade pattern is because carry trades of various types have become dominant across financial markets. Interest rates have been extremely low and yield-seeking investors and businesses have come to accept that central banks and governments stand behind markets and, when it comes to the crunch, will use all their bailout powers to support asset prices. This has made all types of carry trades look very attractive.
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There is a more subtle consequence of the growth of carry trades, which is their impact on liquidity. Carry trades make markets more liquid. The presence of carry traders makes it easier and cheaper for riskier or levered companies to issue debt or for stockmarket speculators to use leverage and hedge risk, or even for home sellers to sell their property. But, by the same token, when carry traders are forced to abandon their trading or get out of their trades and transactions, then that market liquidity evaporates – as we have seen.
When carry trades crash, levered businesses and financial institutions can lose access to credit and face insolvency. There are demands for central banks to support liquidity and asset prices. To do this, central banks themselves replace carry traders who have exited their trades. This means suppressing market volatility, taking on board the risks that carry traders are shedding and adding the liquidity to markets that they are now taking away. For investors the difficulty is knowing when central banks and governments have done enough to restart the cycle. Unfortunately, this is probably impossible to discern from statistics or from studying the specific policy actions they take. What we can do instead is try to glean insight from the reactions of the financial markets themselves.
Three scenarios
There are broadly three possible scenarios. First, central banks and governments do enough to encourage the carry trade cycle to start again, as in 2009. Second, the measures that central banks and governments have implemented actually prove very inflationary. This would end the carry trade cycle for good as it relies on low interest rates and low inflation, which suppress volatility. High inflation would ultimately mean high interest rates and high volatility. In the third scenario, central banks and governments prove to be impotent against the implosion of leverage. This would mean a deflationary collapse of the whole financial system. The third scenario is relatively unlikely at this stage, although not impossible. If it were to happen a clear warning sign would be market interest rates falling into deeply negative territory.
By contrast, in either of the first two scenarios, market interest rates would initially creep up. Then pay close attention to market volatility. The second, inflationary, scenario would see both interest rate and stockmarket volatility remaining high or rising. The growth of carry trades is associated with the suppression of volatility so in the first scenario volatility would tend to fall and stay low. It is the difference between repeating the 2010s or the 1970s, with very different implications for long-term investors. Markets’ behaviour has been about volatility – specifically the lack of it until very recently – and volatility can reveal what the future holds.
• Tim Lee is an economist and a co-author, together with Jamie Lee and Kevin Coldiron, of The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (McGraw-Hill, 2019)
