Archimedes and the carry trade

I'm in the midst of reading the works of Peter Dale Scott- a most enjoyable experience as the depth of the research is matched by the quality of the prose. Thus I'll take the easy way out today and present an internet exchange on carry trades and leverage some might find interesting.
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Give me a lever long enough and a fulcrum on which to place it, and I shall move the world. Archimedes

A friend of mine recently expressed his concern over the prevalence of carry trades, and their reputed effects, in the FX and interest rate markets.

I responded that the problem, in my view, wasn't the carry trades themselves but the leverage used therein.

After a bit of to-ing and fro-ing, my friend asked: When the BOJ sets rates at 0% and the FOMC sets them at, say, 5%, doesn't this ultimately cause a net creation of credit into the system (albeit temporarily) which sets up an arbitrage system guaranteed (engineered) for those with access to that rate differential?

To which I responded: Yen and the US$ are two different currencies. They represent two very different sets of assets and liabilities. Selling Yen and buying US$s carries substantial risks: 1) inflation in the US is far higher (another way of saying that real rates are not so far apart as the nominal difference suggests) 2) the c/a position is reversed. If the currency market began to fear, say, capital controls, the Yen would rise very quickly vs. the US$.

This sense of "free money" via the carry trade, was, in my view, what tore the GBP out of the ERM in 1992. (It was also a prominent feature of the Asian crisis, when people sold YEN or even US$s to earn much higher Thai or Indonesian rates) Just as today, when investors are sure that the BoJ won't allow the Yen to strengthen too much, allow the US$ to fall too much, or that in such an event THEY COULD HEDGE (the flaw in the Black Scholes option pricing formula) investors in the early 90s were sure that the BoE and BBK would keep the GBP/DEM cross rate within the ERM band. Thus one sold DEM and bought GBP to earn the carry, assured that THE EXCHANGE RATE WOULD NOT MOVE ADVERSELY AGAINST THE POSITION.

In the event this view proved false. GBP were not DEM.

Today's currency carry trade investors will discover the same truth. YEN are not US$.

These trades, by the way, are not creators of credit. Credit can be created when banks that fund, say, hedge funds, allow them to trade with leverage, which was my original point.

Do you keep all your cash as cash? or do you look to place it in vehicles that provide more income? Thus you might sell cash, and buy a CD, or a bond, or even a foreign currency CD or Bond, hoping to earn the greater carry but not suffer the risk of investing in a different instrument. Thus you might have "carry trades" in your portfolio. But you do it without leverage, which allows you to keep a much cooler head.

Imagine trying to trade Gold with leverage of say 20 to 1. As we both know, it isn't fun to watch Gold lose 20%-30%, but at 20-1, 5% is death. Thus the craziness when rallies start to fade and roll over.

The problem arises when an LTCM has US$2B under management and US$100B in positions, lent them by banks, most of which seeks to arbitrage what they perceive to be "free money". Thus a 5% move in the underlying position, like the YEN/US$ exchange rate, wipes them out. A 20% move starts to make the banks who allowed the leverage, nervous, which is, in part, where the "contagion effect" comes from.

In most currency crises I've witnessed the problem was leverage; within the banking system itself, and/or the wider financial sector. Leverage always starts out by damping volatility only to increase it dramatically when unwound, as it must, so long as man confuses himself.

My guess is that you are imputing to the phrase "carry trade" a far wider range of events than the true meaning of the phrase denotes. A great many writers in the financial press do the same thing, which may be where your sense of the phrase arose.

But your "radar" for bad smelling things seems quite intact. Just as the equity mania smelled bad, (and was made far worse because of leverage) and the housing mania smelled bad (and was made far worse because of leverage-10% down is 10-1) so too do some of the cross currency carry trades smell bad. These trades are bad news, because there are no free lunches, at high leverage, they often cause crises.

On the plus side, such crises are when we get our pay day for owning hard currency.

I wonder if Archimedes ever imagined the world that would eventually be moved was the financial world.