Why the loss of the Carry Trade is bad for gold.
I think tooearly is right. Basically carry trade = liquidity. Let me just try and explain how.
Lets start at the basics. What is a carry trade? I found this definition of a carry trade:
financial-dictionary.thefreedictionary.com
Carry Trade
A trade where you borrow and pay interest in order to buy something else that has higher interest. For example, with a positively sloped term structure (short rates lower than long rates), one might borrow at low short term rates and finance the purchase of long-term bonds. The carry return is the coupon on the bonds minus the interest costs of the short-term borrowing. Of course, if long-term interest rates unexpectedly rose(and long-term bond prices fell as a result), the carry trade could become unprofitable. Indeed, if this occurred, there could be a number of investors trying to unwind the carry trade, which would involve selling the long-term bonds. It is possible that this could exacerbate the increase in long-term interest rates, i.e. push the rates even higher.
The example given is of the simplest carry trade which involves only the yield curve. Today most people, including myself, actually mean the currency carry trade when they refer to the carry trade. The currency carry trade is the short sell of a low yielding currency to fund a position in a high yielding currency. Sometimes people would even mention a gold carry trade. Technically the gold carry trade would involve shorting gold (a low yielding asset) to fund a position in bonds (the high yielding asset). However, the opposite position, borrowing a low yielding currency to hold gold, has also come to be known as a carry trade. Anyone using the "gold carry trade" in this way expresses his conviction that gold has a real yield due to monetary expansion. Because of this ambiguity I will use "carry trade" when I mean the general strategy of benefiting from yield differentials, "currency carry trade" when I mean a carry trade on currency yield differentials and totally avoid the "gold carry trade".
Let's note at this point that all types of carry trades are similar in a way to trying to arbitrage a violation of the one price rule. There should be only one real interest rate so how come there are so many nominal interest rates? The carry trader assumes that whatever is the reason for the interest rate differential it will probably continue to dominate and he can safely take advantage of a "hole" in the market. What is important for me is the display of "what has been will continue" attitude. The exact same attitude would attract the carry trader to hold the best performing currency look-alike of resent years, gold. Why should we care if carry traders hold gold positions side by side with their emerging currency positions? Isn't gold the absolute opposite of the Turkish Lira or the Brazilian Real? It is. However consider this report by the Financial Times on what they refer to as the "butterfly effect". This is back in February 25.
registration.ft.com.
…in possibly the ultimate example of the butterfly effect, this week's ructions in Reykjavik snowballed across the globe, setting off an avalanche of sell orders in emerging markets from Brazil to Indonesia. The catalyst for chaos initially seemed to be country-specific. Fitch Ratings downgraded Iceland's debt, citing an "unsustainable" current account deficit, drawing parallels with the imbalances that helped trigger the 1997 Asian crisis. The Icelandic króna promptly tumbled, losing 9.3 per cent of its value against the US dollar in a day-and-a-half as it slid to a 15-month low. Icelandic stocks and bonds also headed south. But the icy blast spread, prompting the Brazilian real to fall 3 per cent, the South African rand more than2 per cent, the Indonesian rupiah and Polish zloty1.5 per cent and the Mexican peso and Turkish lira 1 per cent. The contagion was primarily due to traders' need to liquidate profitable positions in order to fund their Icelandic losses. With Icelandic interest rates having doubled in two years to 10.75 per cent, carry trade investors have piled into Reykjavik. However, for traders who had borrowed in euros, the króna's sharp slide wiped out more than a year's worth of carry trade profits in one fell swoop. These very same speculators, many of them hedge funds, will have built long positions in a plethora of other high-yielding currencies as well. Hence selling mushroomed as positions in one country were closed to fund losses in another, prompting further losses. "These countries may be unrelated geographically but they are not unrelated in portfolios," said Tony Norfield, global head of FX strategy at ABN Amro. "What starts as a trimming back of a position can turn into an avalanche."
As I came to realize, this is a short-term model example of how a liquidity contraction operates. The margin call is the basic principle of all liquidity contractions. Some early positions are liquidated either because of profit taking or because of an external shock. Losses that have accumulated in one position are offset by liquidation of other profitable positions, which in turn crate losses for someone else. The rush to liquidity needs no fundamental reason. Once it starts it is a self feeding event and the cause for the chain reaction is no longer relevant. The conclusion here is that some of the correlation between seemingly different assets can be explained by simply being held in the same portfolio. The movement of liquidity, the true wave that lifts all and lowers all boats, should be properly measured as changes in the typical marginal buyer portfolio. I use this page to keep track of what I figure is the most common, momentum driven, portfolio:
www2.barchart.com.
Until June, I used hold some of the first lines in this portfolio, this is until I realized how this portfolio interacts with liquidity. It is all about liquidity. The particular stories of every line make very little difference. There is much more movement of the entire portfolio then there is movement in the ranking of positions. If there is excess cash they all rise. If excess cash is withdrawn they all go down. And the Financial Times story about the butterfly effect explains why this is so.
This is what Gorge Soros had to say on June 13 about the mid-May drop in emerging markets:
news.moneycontrol.com.
I think we are in a situation where almost all the asset classes will be under pressure or are under pressure and the main reason for that is the reduction in liquidity. What people do not realize is that the Japanese Central Bank has withdrawn something over USD 200 billion worth of excess liquidity from Japanese banks. Now that money was not put to work in Japan because there was no room for it, a lot of that went abroad, went into emerging markets, there was a so-called carry trade and it is not that suddenly people are risk averse. It is really that liquidity has been drawn out of the market and that is affecting emerging markets. So the markets went down because Latin America was hit.
Makes sense doesn't it? One last quote just to show that there is always someone talking about it before it happens. Paul Mampilly of Capuchinomics wrote on February 27:
capuchinomics.com
The simultaneous end of easy money in the US, Europe and Japan, beyond putting the kibosh on carry trades will also pressure asset prices in general. Gold, another carry trade favorite is unlikely to escape punishment. Gold's traditional role as a bulwark against extreme currency fluctuations has been compromised due to the success of its ETF security and its involvement in the carry trades versus the Dollar and Yen. During the next crisis, we expect gold to act like any other correlated asset and decline in line with other markets.
YanivBA.
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