Crescenzi on the carry trade:
The large amount of leveraged fixed-income positions has yet to be unwound. A key dynamic that has helped to keep interest rates low has been the popularity of fixed-income strategies that depend on low interest rates and a steep yield curve. In particular, the so-called "carry trade," which involves borrowing money at or around the fed funds rate (now at 1%) and investing in higher-yielding instruments such as short-term Treasuries, has had a major influence on the bond market. Not only has it contributed to the decline in Treasury yields, it has also been a factor behind the narrowing of credit spreads, as many investors have used their borrowed money to purchase higher-yielding corporate bonds, including high-yield bonds.
Evidence of the large amount of involvement in the carry trade is apparent in two key indicators. First, there are a lot of repurchase agreements (repos) outstanding, a key source of financing for the carry trade. Repos are widely used by Wall Street firms and investors to finance the purchase of securities. (A repurchase agreement is a sale of securities coupled with an agreement to repurchase the same securities on a later date. It is essentially a collateralized loan, with the interest rate generally close to the fed funds rate for short-term agreements.) As of April 7, there was $2.54 trillion in repurchase agreements outstanding. That's over $1 trillion more than existed when the Fed began its series of interest rate cuts in January 2001.
Further evidence of the magnitude of involvement in the carry trade is apparent in the data on bank holdings of securities. As a percentage of total assets, bank holdings of securities have increased to about 26% from 22.4% in January 2001. The increase is similar to the increase that occurred just prior to the bond rout of 1994, when bank holdings of securities were also at about 26%, a sharp increase from several years earlier when it stood at close to 20% of assets.
Adding to the concern about leverage is the growth of the market for mortgage-backed securities. It is now about 50% larger than the Treasury market, a big change from just a few years ago when the Treasury market was larger than the market for mortgage-backed securities. This means that the influence of the mortgage market, which would be adversely affected by a rise in interest rates, could have a greater impact on the bond market when interest rates rise. |
