PHASE 1:
Rising home values encourage a proliferation of sub-prime mortgages sales.
Sub-prime mortgages become the cornerstone of structured financial products (ABS).
Increasingly opaque ABS (CDO etc) facilitate a proliferation of this asset class.
Rapidly increasing sales of ABS allow liquidity conditions to improve even as credit quality deteriorates.
Liquidity manifests itself in abundant short term (wholesale) funding.
Short term funding is used to purchase higher yielding assets (either higher risk or longer maturity).
This “carry trading” pushes risk premiums even lower, promoting a “chase” for yield.
As yields compress further, more leverage is needed to garner the same results.
Carry trades now dominate global investing patterns.
The USD becomes the main casualty of the carry trade.
Emerging Markets and commodities become the main beneficiaries.
Higher commodity prices slow consumer spending in the West and increase inflation in the East.
Expected policy responses (notably by the Fed) drive the USD lower and commodity prices higher – creating a vicious circle.
The cycle is broken when the music stops playing for the ABS issuers (triggered by the collapse of the Bear Sterns CDO funds) – just as commodity prices have driven the US consumer into recession.
Lehman’s default removes all the other musical chairs, in one go.
The world de-levers.
THE LARGEST CARRY TRADES IN HISTORY ARE FORCED TO UNWIND.
The US dollar becomes the main beneficiary of unwinding carry trades.
Emerging Markets and commodities become the main casualties.
High correlations ensure that de-leveraging in one asset class is swiftly followed by de-leveraging in other risk assets.
PHASE 2:
This brings us to the policy response. The above perspective is essential in understanding what the Fed subsequently tried to achieve. The evaporation of trillions of dollars worth of carry trades meant the Fed was forced to use its balance sheet to fill the void.
The irony, of course, is that carry trading (selling low risk/low yield assets to buy higher risk/higher yielding assets), based on artificially available and cheap short term funding, was the cause of the credit crisis. However, the Fed had little option but to provide the exact same poison – I suppose much in the same way as one might give a heroin substitute to an addict suffering from too severe withdrawals.
In both cases, however, it is clearly not the long term solution – the side effects will eventually outweigh the benefits. And that is where we currently stand, with the inflection point passed somewhere during the course of QE2.
Once the initial liquidity black holes were filled, subsequent liquidity found its way into speculative carry trades (Emerging Market currencies and commodities) which hindered, rather than helped, global growth.
POLICY THEN CHANGED.
After 3 years of deliberately and explicitly recreating an even bigger beast of a carry trade, policy has changed.
THE FED IS NOW UNDWING THE BIGGEST CARRY TRADE IN HISTORY.
PHASE 3:
Again, the above is essential to understanding how markets are likely to evolve in the coming months. The Fed has DELIBERATELY broken the carry trades – a STRONG US DOLLAR POLICY IS NOW IN PLACE.
Full QE, let alone “twists” and “shouts”, has little more to offer. The only policy tool of any power left (and it has considerable power) is crushing the speculative element of the carry trades: INFLOWS to Emerging Markets, and COMMODITIES.
THE DAM HAS JUST BROKEN ON 3 YEARS WORTH OF CARRY TRADE BUILDING.
DO NOT EXPECT THE PROCESS TO COMPLETE IN A FEW WEEKS - LET ALONE DAYS.
DO EXPECT ENORMOUS COLLATERAL DAMAGE TO OTHER RISK ASSETS. THIS IS NOW THE “ACCEPTABLE” SIDE EFFECT OF POLICY.
Anyone long a Copper/ Short USD carry trade, for example, would have lost 30% over the past 3 weeks alone! Anyone more than 3x levered would clearly have been entirely cleaned out.
Given the ferocity of both the EM currency and commodity reversals, it’s hard to believe that more than a small fraction of those involved in these trades managed to unwind a meaningful amount of their positions. Again, anyone with any sort of leverage will now be in an impossible position – hoping for a massive bounce. If everyone’s hoping for a huge bounce, and the trades are exceptionally crowded, then I’d put the chances of those wishes being granted at zero. On the contrary, margin calls will soon start to bite, and de-leveraging of other risk assets will accelerate.
My biggest fear – given the role of the Chinese in commodity speculation – is that forced de-leveraging of commodities could lead to de-levering on the real estate side there, opening up a whole new front in the war against deflation.
In conclusion, one needs to see recent events from the proverbial “30,000 foot view”. This isn’t about the market discounting a US recession – or a drop in earnings (forget P/Es for the moment) – it is about changing policy and the resulting unwind of concentrated risk trades. This creates the wanted effect of lower commodity prices (good for the vast majority of the world), but it also creates the unwanted side-effect of higher volatility in risk assets, for a short period at least. The stakes are clearly being raised by the inertia amongst European leaders to their solvency issues, so I’m not in any hurry to change stance here. I remain negative on cyclical sectors and extremely negative on commodity related investments. Consumer Discretionary – particularly Restaurants – would be the only cyclical area I’d have decent exposure to – but that’s more as a hedge (as markets could easily bounce). On the defensive side I would favour the domestics over the internationals (i.e. Utilities and Telcos) – as the US dollar is likely only at the beginning of a major move higher. This is not meant as a trading call - markets don't tend to go in straight lines - but I would use any oversold bounces to continue to position defensively. Anecdotally, I still get the impression investors are confusing defensive with neutral, so I suspect we've got a way to go yet..
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