Like any market participants, everyone wants to get the best deal. Currency and bonds traders want to borrow in the cheapest currency and then invest in the bonds that are producing the highest interest rates. It’s called the “carry trade”. There are two huge, developed markets that are still implementing quantitative easing (QE) in some form — Japan and Europe. Europe is implementing QE like the U.S. did by buying 80 billion euros in bonds per month and Japan is still tinkering with NIRP, a negative interest rate policy. Negative interest rates means investors lock in a coupon loss (negative interest rates) on the bond; they are investing money for a loss. Neither of these economic states is natural or sustainable. They manipulate the market to alter the risk/reward calculus of investors. These manipulations by central governments are affecting all asset classes.
What Is the Carry Trade?
The math is pretty simple — who has the lowest real rate to borrow from and who has the highest real return to invest in? The math is about real return, which is interest rate — inflation rate. Right now Japan yields 0.10%, and there is no inflation, so their real return is 0.10%. German bunds have some negative rates, but their 10-year has a yield of 0.40%. There is inflation estimated at 1.1%, so Europe’s real return is –0.70%. The U.S. 10-year started the year with a yield of 2.7% with inflation estimated at 2.0%. That means the U.S. has a real return of 0.70%.
If the U.S. doesn’t get as much inflation as expected as fast as the market expects it, its bonds could still produce a higher yield and, therefore, continue the carry trade. As long as Japan has negative rates and Europe has negative real rates, the U.S. treasury yields can stay suppressed because more investors are buying treasuries under this circumstance. And remember, bond prices and their yields move inversely. That means the more people who want to buy U.S. Treasuries, the more their yields may be pushed down.
Predictive Indicators — Why We Should Care
The predictive work is to calculate the real rates of the U.S., Europe and Japan. When there comes a day that the real return in either Japan or Europe creeps higher than the U.S, then the carry trade may get unwound by speculators and investors.
If the carry trade has to be unwound, then you’re going to see traders scramble to sell U.S. treasuries and buy whatever bonds they were borrowing from. Many times speculators borrow in lower-yield currencies to then buy several different asset classes, including stocks. That is the definition of the carry trade. So when the carry trade gets unwound, market dislocation and volatility can happen through several markets and asset classes. As investors, we can watch Japan and Europe for rising rates. If we see rising rates, then we have to remember that they may bring market volatility and we should act accordingly.
This system is how we could get lower 10-year rates even when the Fed is raising short-term rates. Inflation and other bond markets set the tone for which way money is going to flow. Watch inflation and watch Japan and Europe Central banks for a policy change and you’ll be one step ahead of the crowd.