The Investor

Can’t Carry the Carry Trade Anymore

Why the market isn't showing interest in good economic news.

By 5.6.04

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Investor's Business Daily's April 30 sidebar note may as well have been bannered in 48-point type across the whole front page: "Confirmed rally all but dead," said the "Current Outlook" comment in "The Big Picture." For about two weeks, the stock market averages had been collapsing at any decisive sign of good economic news: Boom in new home sales, crash. Lower unemployment figures, selloff. Higher Gross Domestic Product, outa here.

What's going on?

"Interest rate worries," the major news stories usually say. But that really doesn't cut it. Yes, the market's players think the Fed will raise interest rates in response to a strengthening economy. And yes, it has to happen some time.

The real worry centers on what institutional types have been talking about for at least six months: The hazards of the "carry trade."

With interest rates held artificially low for such a long time, large financial institutions have been "hooked," as some commentators have said, on the carry trade: Borrowing at one percent, buying at four percent. The amounts involved are huge. Business Week (April 26) reports, "Net borrowings by Treasury securities dealers, including big Wall Street banks, are up to nearly $800 billion, double the level of three years ago." Add in another $100 billion in Treasury purchases by leveraged hedge funds and by financial institutions in Caribbean tax havens, stir 35 percent leverage into the mix, and you have the makings for a broad-based disaster when the Fed raises rates and thereby narrows spreads.

As The Economist put it in its April 24-30 cover story, "Even though the Fed is widely expected to raise rates at some point, the incentive to keep generating profits is great -- and every bank thinks that it will be clever enough to move first. The biggest punters, according to a friendly risk manager who crunched the numbers on a comparable basis for The Economist, are Citigroup, UBS (formerly UBS Warburg and UBS Paine-Webber), Goldman Sachs, Deutsche Bank, J.P. Morgan Chase and CSFB (Credit Suisse First Boston). Some have more capital to cushion them than others. The most thinly upholstered of the big players are Deutsche and Goldman. If markets move sharply against them, banks and other similarly leveraged investors are forced either to dump positions or to stump up more capital. Almost invariably they choose the former, which can turn a fall in financial markets into a rout."

More than one observer has likened the behavior of those big banks to a game of chicken. All the big guys want to make as much money as they can, right up to the last moment. And, given the endemic hubris of the Wall Street trader type, they all think they can call the moment spot-on when the Fed is just about to act. Not likely. That means everybody runs for the exits -- sells, or tries to -- at the same time.

I interviewed one of the Spectator's regular readers and correspondents, a stockbroker who has to remain anonymous because of the requirements of his firm. He's a self-described contrarian.

"What bothers me," he says, "is that we've got this 100 percent one-sided view that interest rates are going to go up" -- and that everybody thinks, he did not add, that they know just when that will happen. "I just can't imagine that we would have a phenomenon where all participants are correctly positioned for a single event. It just doesn't seem possible.

"The market does its best to make everybody look like an ass -- that's it's job."

For a growth stock trader like me, the message is clear enough. You don't have to hit me over the head twice. I'm out.

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About the Author

Lawrence Henry writes every week from North Andover, Massachusetts.