Pennsylvania Investment Observer

Unwinding of the Carry Trade

by Daniel J. Nestlerode

Historically, low interest rates have created a technical condition in the investment markets including the stock market, bond market and the commodities markets. This is the event that occurs when short-term rates are very low and money is easily available and a group of aggressive investors play the difference between the low short-term interest rates and the higher interest rates and potential returns available in longer-term bonds, commodity prices and stock prices.

The bond hedge is a fairly easily understood phenomenon. Astute investors have borrowed billions of dollars at rock bottom interest rates in the short-term market and purchased three, five, ten and even thirty year government bonds. The risk these investors take is one of changing interest rates. As long as short-term rates are lower than long term rates they continuously make the difference between the two rates or the spread. Another way to understand this is that their cost is less than their return.

More adventuresome investors borrow money in the short-term markets and buy equity in stocks or commodities in order to participate in the changes in prices that result from a recovering economy. Normally, when the economy is in a recession, commodity and stock prices are depressed. When the government moves to lower tax rates and the Federal Reserve lowers short-term interest rates, there is a period of time between these actions and the recovery of the economy. As the economy recovers, demand for commodities picks up and commodity prices rise. Likewise, as economic activity increases, eventually sales and earnings at corporations increase and stock prices rise. There are investors who borrow billions of dollars in the short-term interest rate markets and buy commodities and/ or stocks hoping to catch this change in equity prices. This activity, called the carry trade, is what contributes to the “V” shaped recovery in stock prices at the bottom of the decline in prices. A lot of buying occurs in a short period of time, pushing prices rapidly off of their low points.

Now the Federal Reserve is moving to increase short-term rates, perhaps at the June meeting of the Board. As they increase short-term rates, the cost of the carry trade increases and investors begin to unwind their positions, selling long-term bonds, stocks and commodities and paying down their short-term debt. Often, there are dramatic declines in equity prices over short periods of time, as what was demand in the carry trade becomes supply and investors seek to avoid losses on their equity positions by selling before the crowd. This leads some stock prices to gap down on no news or even good news, defying the usual logic that is employed to buy and hold stocks by long-term investors. Rising short-term interest rates will cause some dislocations in stock, bond and commodity prices as the carry trade leaves the markets.

This activity is not fundamental, but rather technical in nature. It is pricing influenced primarily by low short-term rates and aggressive investors’ attempts to benefit from these rates. As these carry trade positions are sold out, fundamental concerns will once again dominate the markets and equity and bond prices will be based on the outlook for sales and earnings growth, corporate news and earnings reports, estimates of inflation and the other usual factors.

For the non-carry trade, sudden declines on otherwise solid companies should be viewed as buying opportunities. The unwinding of the carry trade is a temporary condition. Eventually, fundamental conditions will again become the driving force behind stock, commodity and bond prices.

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