We’ve seen this movie before
The first known instance of the carry trade goes back to the 1950s, when retail investors (who remembered the stock market crash and didn’t trust banks) began squeezing out extra yield by levering up Treasuries. This was another instance of what’s now referred to as “financial repression,” where rates are kept so low that entities who rely on interest to survive (think retirees, pension funds, and insurance companies) were struggling mightily. People were arbitraging the yield curve for a handful of basis points, and this approach went awry when the bond market crashed in 1957.
The Japanese “yen carry trade” was a staple of the real estate bubble years. Japanese banks would borrow at virtually nothing and invest in higher-yielding sovereign debt—especially New Zealand debt, Australian debt, and Icelandic debt. The yen carry trade is one of the big factors in the crisis in Iceland. The common theme was problem banks investing in low-risk assets using a large amount of leverage. The Japanese banks also invested heavily in European sovereign debt. During the crisis, you could almost anticipate the velocity of selling based on changes in the Euro-Yen cross rate.
We saw it in the U.S. after the Savings and Loan crisis. After the Resolution Trust Corporation wound up the bankrupt S&Ls (savings and loan associations)—and also after the Texas real estate bubble collapsed—the banks were in rough shape. The Fed aggressively lowered interest rates, and banks (and other entities) found their way into mortgage-backed securities (MBS). As the bond market rallied, they made high returns, but it all came crashing down in 1994, when the Fed unexpectedly raised interest rates. Notable blow-ups included Orange County and mortgage arbitrage hedge fund Askin Capital Management.
The carry trade is global
You can see that the carry trade wasn’t only a U.S. Treasury phenomenon—in fact, it was global. The chart above shows the average of G7 sovereign yields. The G7 nations are the United States, the United Kingdom, France, Italy, Germany, Canada, and Japan. You can see that G7 sovereign yields started rising on pretty much the same day that the U.S. ten-year bond rolled over.
There really isn’t much of a consensus on what caused the top in global bond markets. Given the U.S.-centric worldview of the financial press, some pointed to the April jobs report, which in all honesty wasn’t so great as to cause a worldwide sell-off. Another theory is that the cause was the late-April release of the Financial Stability Oversight Council’s Annual Report, which went in depth, warning the financial sector (particularly mortgage REITs) about convexity risk. Convexity risk is a type of interest rate risk that’s of particular importance to holders of mortgages or MBS. Finally, it’s well known that the big global banks are in constant contact with the Fed. It’s possible that these banks were given a heads-up that quantitative easing was coming to an end. Interestingly, the PIIGS euro sovereign debt continued to rally for a couple weeks after everything else was selling off.
© 2013 Market Realist, Inc.