How markets will reveal what the future holds

The crash would have happened even without the virus, says Tim Lee. To gauge whether we are headed for another decade of steady gains or a repeat of the 1970s, watch volatility.

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. 

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.

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.

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• 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)

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