A tidal wave of repos and the best carry trade ever

By Bram Nicholas

3 March 2020

On 17 September, 2019, the US Federal Reserve (Fed) announced it was going to provide the US financial system with extra liquidity following a sudden spike in short-term money market rates. “Extra” liquidity was perhaps a bit of an understatement. Over the next five and a half months, the Fed would proceed to inject an average of $60 billion per day into the overnight repo market, a market where banks and other financial institutions lend cash to each other against collateral –mostly in the form of US government securities.

In addition to the overnight repos, the Fed began conducting “term repos” (repos lasting longer than one day) to meet additional liquidity demands. Having already extended the period of pledged repos twice, the Fed recently announced a further extension, this time until the end of the second quarter of 2020, to feed what appears to be a bottomless pit of liquidity demand.

Naturally the question everyone is—or should be—asking is where this sudden demand for liquidity has come from. The answer is that it is the result of a combination of factors. One is the debt servicing difficulties facing a number of major US companies (Boeing and WeWork spring to mind) resulting in an increase in demand for liquidity to meet their short-term liabilities.

A second is the recent shale-oil fueled rise in US exports, which is reducing the trade deficit rapidly and consequently squeezing the supply of Dollars internationally. Third, and perhaps most important of all, is the demand for Dollars arising from the massive inflow of foreign capital into the US, resulting from what can only be regarded as the best “carry trade” ever.

The carry trade explained

The carry trade is an old concept in the financial world and describes one of the most basic strategies: Borrow money where interest rates are low and lend or invest that money where interest rates are high. The main risk in the carry trade between countries is the movement of the exchange rate, since this could potentially wipe out the gains from the interest rate differential. However, if the exchange rate is fairly stable, or, better still, the currency of the high interest rate economy is appreciating as a result of capital inflows into that economy, you get the ultimate carry trade.

It all started in Japan

The present dollar carry trade can be argued to have started with the Bank of Japan (BoJ) deciding in the early 1990s to adopt a policy of ultra-low interest rates to fight deflationary pressures and stimulate the economy. By 1995 the 3-month Japanese LIBOR rate, a short-term rate for uncollateralized lending between banks, had fallen from 7% to 0.5%. By 2001 it was at 0%, where it has remained ever since, with the exception of a brief rise to 1% in 2007/8.

After having successfully reduced interest rates in the short end of the money market, the BoJ decided in 2001 to reduce bond yields in the long-end of the market. This led to the BoJ becoming the first central bank ever to purchase large quantities of securities (mainly government bonds), i.e. to adopt what has come to be known as Quantitative Easing (QE). The result was a fall in 10-year bond yields to near zero, considerably lower than rates in both the US and Europe, but at the cost of bloating the BoJ’s balance sheet – its assets being currently the size of Japan’s entire GDP.

 

Differentials understating the carry trade

The extraordinary measures undertaken by the BoJ resulted in considerable and protracted divergence between Japanese and US interest rates, leading to attractive differentials by any investor’s standards. But the differentials alone understate the significance of the carry trade. When the choice is between interest rates of 5% and 7% the (currency) risk might not be worth taking. When the choice however is between 0% and 2%, taking the risk becomes a necessity for many. Of particular note in this regard are the Japanese pension funds and insurance companies that traditionally relied on government bonds to obtain returns they needed to survive.

Illustrating this necessity is Japan’s Government Pension Investment Fund (GPIF), the largest pension fund in the world, which recently shifted its asset allocation from more than 60% in Japanese government bonds to less than 30%. The risk associated with this loss became very apparent when the GPIF reported a record loss for Q4 of 2018 when US and global markets had corrected sharply.

Europe joins in

Late to the party, but fundamental to the size of the carry trade with the US, is the Eurozone. After having brought down short-term money market rates during the 2009 global financial crisis following a similar move by the Fed, the president of the European Central Bank (ECB), Mario Draghi, proposed to further reduce interest rates in 2012.

The 3-month LIBOR rate fell to 0% that year, entering negative territory in 2015 to remain at around -0.3%. In late 2014 the ECB also adopted QE, pushing government bond yields in most of the Eurozone’s member states into negative territory for the first time in history (see previous blog in this series).

Negative interest rates have since spread to all corners of the Eurozone’s financial system. In the Netherlands, for example, private banks have in some cases started charging their customers between 0.3% and 0.5% for simply holding cash. While the US Fed had adopted a similar low interest policy, it began raising rates from 2015 onwards, resulting in a growing divergence between US and European/Japanese rates.

The best carry trade ever

If zero rates make 2% seem attractive, negative rates (paying to lend) make 2% look like a veritable treasure trove. The phenomenon of zero and negative interest rates in Japan and Europe and significantly positive rates in the US thus gave rise to one of the largest capital flows in history. From the early 1990’s foreigners started to invest more in the US than US nationals were investing abroad, denoted by the net investment position of the US turning from positive to negative; a trend which continued to develop to a current level of minus $10 trillion, or half of the US GDP (see chart below).

While the first phase of the carry trade coincided with Japan’s aggressive lowering of interest rates, a marked acceleration took place from 2014 onward with the aggressive QE policies of the ECB. Indeed, net portfolio investments from the Euro Area into the US doubled from $1 trillion to $2 trillion in the timeframe of six years (see chart below). 

Two major developments have taken place as a result of the carry trade. First, the US dollar has remained strong in spite of the sizable US trade deficit. Second, there has been a huge demand for Dollars that has forced the Fed to conduct repos on an unprecedented scale.

Repos, unlimited repos

How unprecedented are the Fed’s current repo operations? The volume of daily repos has certainly been extraordinary, but it has been seen before in times of heightened financial markets stress. What marks this period of repo operations as unprecedented is its duration.

If we consider periods of extraordinary repo operations to be consecutive days of overnight repos exceeding $20 billion, these periods lasted a maximum of 6 days in the financial crises of 2001 and 2008. In contrast, however, the current repo operations have been ongoing for 112 days, with overnight repos ranging from anywhere between $20 to $90 billion per day. (Not to mention additional term repos averaging around $30 billion per day but on a less frequent basis.) Another 90 days can be added to this period given the Fed’s current pledge to extend the repo operations until the end of the second quarter, with no guarantee that it will end even then given past extensions.

The end of the carry trade?

Perhaps the best evidence of the carry trade have been the recent appreciations of the Euro and the Japanese Yen against the Dollar. These appreciations have accompanied the relative collapse in US long-bond yields alongside (and as a consequence of) sharp reversals in US and global stock markets in the last week of February.

As was noted by the Financial Times, it is highly unusual for the Dollar not to rise in times of such market turmoil given that investors usually flock to the currency as a safe-haven. If indeed this marks the end of the best carry trade ever, we might actually see something not seen in a long time; a falling Dollar in the face of a global economic recession.

If, as expected, US bond yields continue their inevitable descent toward 0%, investors – not just those from Europe and Japan – will have to start looking elsewhere for returns. The most likely candidates are the emerging markets – both bond and equity markets. Indeed, the rise in emerging market debt levels compared to those in advanced countries suggest this shift may already be underway.  

Notes

  1. On 3/6/2020 the last repo chart was replaced by a new one for the sake of clarity, using the same data.

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