Market Insight: Soothsayer urges play against overcrowded ‘carry trade’
By Stephen Schurr
Published: May 3 2005 18:05 | Last updated: May 3 2005 18:05
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.
Now, the hedge fund skipper at Balestra Capital foresees signs of an impending seismic shift and has placed his bets accordingly. And 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. Meanwhile, the carry trade has spawned substantial capital appreciation in junk, mortgage notes and emerging market debt. “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.”
Earlier this year, Mr Melcher began putting money to work in the “negative carry trade” – in other words, buying short-term US Treasuries and selling short junk bonds, using an index of junk bonds.
At a time in the market when there seem to be few genuine values that do not involve a great deal of risk, the negative carry trade makes sense. First, it is hard to imagine that the spread between short-term Treasuries and junk bonds would narrow any further, unless one expects junk to start yielding less than Treasuries.
Second, the negative carry trade provides protection against further erosion in market fundamentals. The value of junk depreciates for many reasons, including disappointing corporate earnings, rising interest rates, a loss of confidence in a struggling company’s ability to right itself or an economic recession. The first three have weighed on the markets in recent weeks, and the latest rash of economic data suggesting a weakening US economy has some on Wall Street considering the possibility of the first consumer recession in the US in 14 years.
If the negative carry trade turns out to be a prescient bet, it would most likely mean the broader US market and economy are in for serious trouble. “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”.
At this point, the comfort level so many hedge funds have with leverage will seem misplaced, to say the least. |
