I have long worried that as the carry trade gets less profitable (i.e. the difference between the interest rate on short-term and long-term debt falls), hedge funds would respond by doubling up their bets. From what Jim Melcher of Balestra Capital says, that seems to indeed be what has happened.
Mr. Melcher is talking his book, but his message still strikes me as important. From the FT:
Jim Melcher has anticipated nearly every market meltdown of the past 25 years and profited from them, including the stock market crashes of 1987 and 2000, the bond woes of 1994 and the emerging market crisis of 1998. ... While a market disruption may not come to pass, if it does, “it could be a very nasty scene”, he says.
The manager’s bet revolves around the remarkable resiliency and popularity among hedge funds of the “carry trade” – the practice of borrowing money at low interest rates and investing it in higher-yielding issues such as junk bonds, emerging market debt and mortgage-backed securities. Hedge funds and other investors have made vast sums over the past two to three years on the spread between short-term US Treasuries and the longer-dated issues.
The spreads have narrowed considerably in the past year, making the trade less profitable. Rather than unwind their positions, it is widely believed that many hedge funds have simply used leverage, which sustains the outsize profits on a diminishing trade but heightens downside risks considerably. ... . “The carry trade has been a way for hedge funds and others to make easy money,” Mr Melcher says. “But it’s become overcrowded, and any overcrowded position is dangerous when it unwinds.” ... “I am worried about the fairly broad systemic effects here,” he says.
The preponderance of hedge funds in the carry trade is partly what unnerves Mr Melcher. “Hedge fund guys have a very quick trigger finger. When things start going against them, they get out,” he notes. If there’s any sort of rush to the exit, “there is no easy way out. And because our financial system is interconnected as it never has been before, everybody is going to get hurt”.
DeLong's hard landing scenario hinges, in part, on the assumption that hedge funds will bet wrong on dollar, causing financial distress. I would worry a bit more that hedge funds will get caught betting the wrong way in the fixed income market, whether betting to heavily on curve flattening (a falling spread between short-term and long-term treasuries) or spread compression (a falling spread between risky and risk-free assets; if you borrow short to buy long-term corporate debt, you are hoping to pick up the interest difference, and hoping that the price of the long-term bond rises/ the interest rate on the bond falls).
It seems that Randy Quarles -- the future Under Secretary of Domestic Finance at the Treasury -- is considering reintroducing the 30 year bond. I am all for it. And despite the denials, the prospective financing needs associated with partial privatization of Social Security probably has something to do with the idea. After all, the cash flow savings from "Social Security reform" that offset the upfront costs are VERY long term (and I would say, very uncertain). It is the sort of thing that should be financed with long-term debt. Moreover, even in the absence of partial privatization, with deficits as far as the eye can see (using realistic assumptions) the Treasury probably does need to reconsider its heavy reliance on two and three year notes.
Remember, lots of two and three year notes issued to finance the 2003 and 2004 deficits will start coming due soon (for data on the surge in two and three note issuance, see pages 7, 16 and 19 of this document), and they will need to be refinanced even as the Treasury is seeking to raise new money to cover the 2005 and 2006 and no doubt 2007 deficits.
That said, there is a big difference between replacing $20-30 billion of issuance with two-year notes with thirty-year bonds, and replacing $20-30 billion of ten-year notes with thirty-year bonds. We don’t know if the Treasury is reconsidering its overall plan (see p. 13) to shorten the maturity of the US debt stock. Lengthening the maturity of the debt -- or just no longer shortening it -- does not require resuming issuance of thirty year bonds. It would require issuing more ten-year notes, and fewer bills and short-term notes.
Continue reading "Systemic risk and the thirty year bond ..."
Yes, it is quite high and the 21 moving average climbed above .7. However, we are also running into some serious resistance in the 1975/2000 area. Maybe the trading range (1900/2000) continues for a little while longer... The volume on this attempt is, however, quite anemic, new highs still stuck in the 30/50 area, so I do not expect any dehiscence here.
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