Positive-Carry Trades Often End Badly

A positive carry trade in the bond market is relatively easy to understand. Usually longer maturities yield more than shorter maturities, and weaker credits yield more than stronger ones. Buying a long bond and financing it by borrowing in the short term market thus yields a positive earnings spread each day the trade is on the books. Any decline in the price of the long bond must, of course, be deducted from that positive spread to evaluate the profitability of the carry trade.

How Carry Trades Start, and Tend to Build

When the Fed is perceived to be in an easing stance bond traders tend to start carrying more long bond inventory, financing that inventory in the overnight repo market. Both sides of the trade stand to make money, with the financing cost dropping the longer the Fed eases, and with the price of the long bond generally rising over time in response to the easing.

As profitability in the original trade grows, more risk tends to be taken. That is, the carry trade position tends to increase in magnitude. More bonds are bought, at successively higher prices, the price continues to rise, financing costs continue to fall, etc.

How Carry Trades Tend to End

As with any successful investment (to that point), the first entrants tend to do the best, often because they are just better at assessing trends and risks, but sometimes because they just got lucky. In time, the success of the carry trade draws more and more participants, the result being that the bond market gets overloaded with traders all on the same side of a trade, long bonds being financed short.

The ending is often brutal, with an unexpected Fed tightening or, more likely, an unexpected Fed announcement of an impending policy reversal, causing a fall in bond prices. Those last into the trade, already underwater immediately due to the drop in the asset they hold and faced with an impending increase in financing costs to boot, begin to exit the trade. Others try to follow and some even try to set short positions.

The net result is that those who entered the trade late suffer losses that can be significant, but those who entered early end up quite satisfied with the net result. Carry trades are very popular because, all things equal, they make income with each passing day. Plus, markets, particularly short term markets, tend to trend due to the influence of Fed policy (which always trends.)

The Federal Reserve's Perfect Carry Trade, Established by Law

Until recently the fed enjoyed the perfect carry trade, an unending guaranteed profit established by law.

Every dollar bill and piece of change held by individuals, businesses, and foreigners was first issued by the Fed to a bank in the banking system in exchange for an equal amount of that bank's reserves held at the Fed. That is, the banks traded bank reserve balances for actual currency. Since currency in the vault counts toward meeting reserve requirements, the bank was unaffected.

Not so with the Fed, however. The Fed issues a nearly costless piece of paper to the bank, a piece of paper that represents a liability to the Fed (which is why they all say Federal Reserve Note on them). Offsetting that liability is an asset portfolio that typically was composed of short term maturities like U.S. T-Bills. Similarly, in the past the reserves that banks were required to hold at the Fed were costless, in that until recently the Fed paid no interest on those reserves.

Thus, virtually all of the Fed's liabilities were costless and all of their assets earned the short-term rate available at the time. The perfect carry trade, always profitable, persisting forever, and even growing steadily as the economy and associated money supply expanded over time.

The carry trade was exactly the reason that the Federal Reserve, even after paying all of its operating costs, could remit a significant profit to the U.S. Treasury (and thereby to the taxpayers) each year. One is even tempted to wonder whether the excessive money growth that has been a constant feature of monetary policy ever since the Fed's inception might be due to the carry trade doing better the more the money supply grew.

The Largest, Highest-Risk, Carry Trade of All Time

Over the past several years the Fed has:

1. Decided to pay interest on reserves, thereby exposing the financing side of its carry trade to a new financing risk.

2. Decided to shift its portfolio massively to the long end, thereby exposing said portfolio to the risk of future market fluctuations in bond prices.

3. Decided to increase its portfolio to around $4.5 trillion from a bit under $1 trillion a few years ago.

In other words, should interest rates now rise the Fed will see it's financing costs rise, its portfolio likely fall in value, perhaps significantly, and will be subject to losing on both ends of a $4.5 trillion portfolio.

Conclusions

When a federal agency under the direct control of Congress takes it upon itself to turn a sure annual gain for the taxpayer into a highly risky gamble for said taxpayer without first taking it to Congress for discussion and approval, but just goes ahead and does it on its own, it's time for Congress to intervene. Here are three suggested questions at any future hearing:

1. How much price risk does the Fed portfolio have under various assumptions of rising rates?

2. How much of an income hit will the Fed take under various assumptions of rising rates?

3. Do these risks in any way compromise the Fed's decision-making process, especially when considering whether to raise the short term rate of interest?

Now, admittedly, the Fed has earned a lot of money over the past several years while carrying this trade and that should be taken into account. However, they've also completely overwhelmed the Treasury's decision to extend the maturity of the debt at historically low interest rates, a fact that will be made clear should interest rates ever rise to the point that the Fed runs at an annual deficit and has to go to Congress for its funding, rather than remitting funds annually as it has typically done.

For some concept of the likely outcome in a rising rate environment see the post that started this recent series of posts here at OnTrack Economics: The Fed's Massive Conflict of Interest.