If US investors start buying foreign securities like they buy foreign cars, watch out
There is no way to put a positive gloss on the December TIC report. Total inflows — counting short and long-term flows — were negative. The foreign securities bought by US private investors abroad exceeded the US securities bought by private investors abroad; net private were very negative. Long-term private outflows (net) were around $8.4b, and short-term private outflows (net) were $34.1b. Absent substantial net official inflows ($24b of long-term purchases, $31.5b total) the overall totals would have been far worse.
Isabelle Lindenmayer of the Wall Street Journal put it well.
"The TIC report suggests U.S. investors are starting to find confidence and value in foreign securities much the same way U.S. consumers have long found reliability and thrift from Toyotas and Hondas. Just as worrisome, foreign investors, too, may be starting to lose their appetite for U.S. securities.
… Though the TIC data are an imprecise gauge, they don't bode well for the U.S. ability to finance its huge trade and current account deficits in the long term, said analysts."
Our unnamed analysts are stating the obvious. To finance a roughly $850-900b current account deficit, you need need over $70b of net inflows a month. Not zero. And certainly not a net outflow of $11b.
The disaggregated data continues to frustrate. Overall, according to the TIC data, official investors invested $128.7b in the US in 2006 - up from $87.3b in 2005 but down from $341.6b in 2004. Net long-term official inflows were a bit higher — $185.6b — but still below 2004 levels ($235.6b). The big fall in short-term holdings clearly reflects the $38.5b fall in Russian short-term holdings (Russia moved a lot of dollars offshore in 2006.
Relative to 2004, there was a clear shift toward agencies.
Only the last point really fits other data sources. Based on the COFER data, along with trends in the BIS offshore deposits, Christian Menegatti and I (RGE subscription required, sorry) estimated that official institutions added about $550b to their dollar holdings. A lot of that will be held in banks offshore. But I still suspect the US data is dramatically understating total foreign official purchases.
A couple of examples. China added $78b to to its reserves in q4, $68b after after adjusting for valuation changes. Recorded Chinese purchases of long-term US securities in q4 though were only $20.8b. China reduced its short-term holdings by $10.6b in q4, so net inflows from China in q4 were only $10.2 (assuming I did the math right).
That is way too low for a country that added $65-70b to its reserves — especially when Chinese banks and Chinese pension funds were also likely buying dollars (remember, Chinese q4 reserve growth was well below the estimated q4 current account surplus + net FDI inflows).
The "Asian oil exporters" — TIC slang for the Gulf — didn't do much in q4 either: $2.7b in purchases of long-term debt were offset by a $2.7b fall in their short-term holdings. Oil prices did fall in q4, but, well, the Saudis and the others in Gulf were still clearly adding to their foreign assets.
Voldemort, indeed. (More here)
Relative to $200b plus in q4 reserve growth, the $34b in net official inflows in the q4 data is very, very low. It is possible central banks jsut stopped buying dollars. But all the available evidence suggests that central banks tend to buy dollars when others don't want to. Others clearly didn't want to in December. And if that pattern holds, total central bank dollar purchases were way, way up in q4 2006. Christian and I estimated that central banks needed to add around $150-155b to their dollar portfolios in q4 to hold the dollar share of their reserves constant. Either we are way off, or most of those purchases didn't show up in the TIC data.
(1) Dr. Setser: I haven’t looked at this data series in some time and I am a bit confused for they appear to have changed the presentation. Isn’t $15.6B worth of “net foreign purchases” the relevant figure here? My (old) understanding is that the total includes foreign purchases of US stocks, treasuries, agencies, and commercial papers less US purchases of their foreign equivalents. What is the difference between “net foreign purchases” and this newfangled “monthly net TIC flows”?
(2) If GCCs are “Asian oil exporters,” then you can call me “Chuck Woolery.”
Count me as one of the data points underlying this report, though only a little tiny data point. European and Asian blue chips are just a blue as ours and seemed a lot better place to park savings than an S & P index fund. So far, this has been working out pretty well.
The current level of US interest rates don’t adequately compensate the bond investor for devaluation risk and rising inflation from commodity prices. Moreover, the entire world is just about saturated with fiat dollars to the point that dollar liquidity is increasingly having a destabilizing impact on foreign economies. The estimated $1 trillion carry trade from Japanese yen by Hedge Funds could unravel the debt-infested US Economy with interest rates rising just slightly higher. It is highly unlikely that the Asian Central Bank will monetize an additional trillion dollars. The deflation of the debt bubble in US real estate is just what the doctor has ordered to rebalance the global economy.
And now Japan’s economy is back from the pet sematary, just different, somehow, sort of wobbly and stinky and not so cuddly anymore. It still gives american flight capital the best diversification anywhere, but it might not hold still for the old beggar-thy-neighbor trick any more. We’re going to miss chouki teitai when it’s gone.
Someone is selling all the reportedly massive OTM protection against short JPY postions to the hedgies and to everyone else borrowing yen that needs OTM protection. There must be loadsa’ YEN short-gamma out there by now, but who’s got the old maid?!?!? Thoughts….?
Cassandra,
If I understand you correctly, you are asking who is selling out of the money calls on yen to the hedge funds that are putting on yen carry trades (i.e. being short yen) - is that correct?
If this is indeed your question, my guess for the answer is this: other hedge funds (and some bank prop desks, no doubt) who collect the premiums from selling the naked calls, book them as profit and collect their quarterly bonuses accordingly. Great business while it lasts, but…
The whole hedge fund/private equity system has a fatal flaw: it encourages massive speculation, risk taking and leverage (with other peoples’ money). It’s a no-lose ticket for the managers. If they win they keep 20-25%, if they lose they just fold and get to keep the previous bonuses. Anyone that provides them with capital under these game rules is beyond greedy …. “a fool and his money are soon parted”.
Regards
Hellasious
I am a skeptic and while known to suffer from bouts of cynicism, I have as of yet not made that transformation. While there is unquestionably unmitigated risk-taking due to agency issues, there is some merit to risk warehousing and risk exhange where agents often have a sugar-daddy who takes the other side in sufficient quantity as to not lose the house when all comes unhinged. My question underneath its innocent exterior was really more pointed: the PBoC was a well-known large seller of US bond puts for years. Maybe their doing the same with YEN calls as they attempt to insure they have at least some company in the hot seat.
I know nobody really knows, but…
Is this the beginning of the endgame?
Could the TIC data shortfall be mainly due to year end effects? It seems to me the dollar always weakens in December on this shortfall.
Cassandra — doesn’t the PBoC have a bit more influence on the bond market than on the yen? selling insurance against a risk that is partially a product of your own decision making (A big shift in the bond market) is one thing; selling insurance against something unexpected coming out of japan is quite another.
Full carry. Maybe. I should have done a comparison with December 04 and December 05.
From Bloomberg, Chinese Central Bank raises reserve ratio to 10 percent.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aTxUrJ4of98w&refer=worldwide
Feb. 16 (Bloomberg) — China ordered banks to set aside more money as reserves for the fifth time in eight months to cool inflation and investment in the world’s fastest-growing major economy.
Lenders must put aside 10 percent of deposits from Feb. 25, up from 9.5 percent, the Beijing-based People’s Bank of China said in a statement on its Web site, immediately before the start of a week-long Lunar New Year holiday.
Zhou has increased interest rates twice since April and used bill sales and bank reserve requirements to rein in the supply of money, while resisting calls from the U.S. and Europe to let the yuan appreciate faster. China’s Zhou said the pace of yuan appreciation is “appropriate.”
Brad,
Admittedly it’s a lame thought, though the Chinese can be none too sad to see the YEN carry taking PR heat with the RmB. I was actually more thinking of the PBoC as an example of an official body with an official interest using what is, effectively, material non-public information (their policy willingness to continue to acculmulate USD reserves at prevailing rates of exchange and interest) to garner further income or pin markets by selling puts, knowing with great certainty the options are likely to expire worthless, since they thesmselves will not delta hedge the short gamma and continue to hoover-up the marginal USD at prevailing rates.
Hellacious might be correct and the market, as a result of triangulating fundamentals, interest differentials, what have-you, may willingly be providing the requisite insurance, swallowing the tail risk for a couple of bp’s. However, if it is the large Japanese Banks systematically providing the insurance, one might be forgiven for wondering what - if anything - they have on the other side of the risk proivision, be it priviliged information from MoF or BoJ that nearZIRP will persist indefinitely, or less nefariously, long gamma strippped from embedded options in structured products sold to the army of savers seeking higher yield abroad.
Regarding year-end effects, while December is usually below November, this is something very different.
Historical TIC data is at http://www.treas.gov/tic/.
Cassandra,
It’s not so much triangulation of fundamentals as continuous selling of vols and risk premiums down to near zero, on a global scale.
You need not be a cynic - given your name, all you need to be is a pragmatist. Cassandra was reviled - but she was right, you know. Troy WAS sacked.
some wall street analysts are making the point that these #s are actually bullish for US equities bec they view the foreign investor and foreign purchases of US equities as a contrarian indicator.
If you want to find the sugar daddy of the carry trade, look for people who have “Happy Feet.” Could be bank trading desks and fund managers, they’d qualify. But Cassandra’s named a likely candidate too, who is trying maintain massive export growth while limiting inflation at home, and that’s Chinese govt. If Japan’s currency rises against Dollar, then pressure will be on the Yuan, and it’s possible that the ruling clique could lose their heads, if say, the US govt slaps on some tariffs.
Cassandra’s first post was the most pithy example of unabashed finance-geekery I’ve ever seen. Bravo!
I’ll second Michael Carroll; Cassandra — i want a full explanation — decompressed — over on your blog! and do check out the macro man links (Voldemort …); i found them interesting even if they are dated and even tho macro man seems to think that there isn’t much yen funded carry trading going on right now …
Today, that a bank of my country (BBVA) was buying a bank another bank in USA, here the comments of Peter Schiff on US economy:
Selling our Cows to Buy Milk
On Tuesday of this week we learned that in 2006 Americans racked up a record $763.6 Billion trade deficit, and that two Australian mining firms, Rio Tinto and BHP Billiton, were each contemplating $40 billion bids for U.S. aluminum giant Alcoa. Not only did Wall Street and the media fail to grasp the negative significance of each story, but they also failed to see the strong connection between the two.
By running huge trade deficits, Americans are literally selling cows to buy milk. Alcoa is just the latest heifer headed for the auction block. In other words, because we do not trade enough domestically manufactured consumer goods for those we import, we are making up the difference with our assets instead. To the extent that foreigners are tiring of buying more Treasuries and mortgage-backed securities, they are casting their eyes on industrial assets. Last year’s trade deficit alone provided foreigners with enough dollars to buy twenty Alcoa’s.
Many Americas do not see the downside of such a transfer. In fact, they might even see it as a benefit, as shares of Alcoa would likely rise sharply. However, in exchange for losing one of the world’s preeminent mining companies to Australia, Americans would only be compensated by the return of their paper dollars. Future profits that would have been earned by Americans will now be earned by Australians instead.
Founded in Pittsburg in 1886, Alcoa is now the world’s leading producer and manager of aluminum, employing more than 120,000 employees in 44 countries. Every day Alcoa mines 86,300 tons of bauxite and 27,300 tons of coal, refines 41,000 tons of alumina, smelts 9,575 tons of aluminum, recycles 2,300 tons of aluminum, manufactures 8,810 tons of aluminum products, produces 166 million closures for beverage and food containers, assembles wire harnesses for 20,400 vehicles, generates 96,000 MWH of electricity, and purchases $27 million in goods and services. The sale of Alcoa would be a great loss to the American industrial landscape.
It is astounding that so many fail to see the sale as further proof of America’s economic decline. In his testimony yesterday before the Senate Banking Committee, Fed Chairman Ben Bernanke showed little concern for the trade deficit and its implications for the American economy. If our economy really was as strong as Mr. Bernanke believes, Alcoa would be buying foreign companies, not the reverse. Nations with strong economies use their trade surpluses to acquire choice foreign assets. Nations with weak economies are forced by their trade deficits to surrender those assets.
In the end, when foreign central banks finally allow the dollar to collapse, it’s not just Alcoa, but many other Dow Jones companies that will ultimately fall into foreign hands. After all, a sharp decline in the dollar will make those companies dirt cheap for foreign buyers, who will have little else to buy with the trillions of dollars burning holes in their very deep pockets. America will be reduced to the role of a secondary economic power. Our citizens will work primarily for foreign-owned companies while the profits are sent back to their far wealthier foreign bosses.
Good evening you all
Brad. I’ve really nothing to tell. My original post was just a open question (referring to a number of Bloomberg headlines before the recent YEN3 move about how HF’s were scrambling to buy protection, and that yen call buying was very elevated). And because I think there is tail risk, particulary in USD/YEN, my question’s focus was: is such risk reasonably socialized across the risk-bearing participants (FX Option MMs), or is the market able to lay it off “naturally”, and if it is laying if off “naturally”, perhaps some of your esteemed readers might be able to reveal some colour as the ultimate destination(s). I will admit that the thought of official entity(s) being the ultimate risk repository - either directly or indirectly - crossed my mind, but there could be other theoretical sources, though I do not dismiss hellascious’ & oldvets belief that its the usual suspects, and nothing nefarious.
I raised the point because the two scenarios imply different risk positions for the market in the immediate term. The former, i.e. one with lots of market-makers short Yen gamma, implies the potential for future moves to be exacerbated with any further correction of recent YEN weakness as MMs re-hedge short risk positions (perhaps like the short but sharp moves we saw in Apr/May & Nov. The latter, by contrast, is more stabilizing (as was the PBoC’s selling Bond Vol) since further correction must come from real flow or undwinding, not mimetic delta-hedging. Presumably in a world where reasonable amounts of speculative positions are hedged in way where the risk, ultimately is naturally offlaid, a bit of YEN strength doesn’t beget further YEN strength. Unless like the BoE, they throw in the towel.
NearZIRP more than accomplishes most of TeamJapan’s desired goals, so I would have thought, without having to diddle directly. But perhaps policy conversations shared withdomestic players, that nearZIRP will remain in force is sufficient to embolden their desks to write the O-T-M cover to the market. Yen i-vol appears pretty low overall. On the other hand, you may recall that Japanesae banks and insurers were the primary (and gleeful!) sellers of 3-yr Nikkei puts in 1989 & 1990 with strikes they do not care to mention. Oooops!
I expect that most of you will understand this piece in french by an european think tank:
“Crise systémique globale - Avril 2007: Point d’inflexion de la phase d’impact / Entrée en récession de l’économie US.
Comme annoncé dans le GEAB N°11 en Janvier dernier, le brouillard statistique se dissipe et l’évolution de l’économie US apparaît désormais clairement (vente de détails au point mort en Janvier 2007, déficit commercial record en 2006, révision à la baisse de la croissance US pour 2006, confirmation du ralentissement économique par la Fed, faillites en série des organismes de prêts hypothécaires, poursuite de l’effondrement de l’immobilier US,…).
Ainsi, en fonction des évolutions propres à chaque composante de l’économie US, c’est le mois d’Avril 2007 qui va constituer selon LEAP/E2020 le point d’inflexion de la phase d’impact de la crise systémique globale, c’est-à -dire le moment où les conséquences négatives de la crise s’accroissent de manière exponentielle. Plus précisément, il va marquer le moment où toutes les tendances négatives vont converger, transformant de multiples « crises sectorielles » en une crise généralisée, une « très grande dépression », affectant l’ensemble des acteurs économiques, financiers, commerciaux et politiques.
C’est donc en Avril 2007 que neuf conséquences directes de cette crise vont converger, Ã savoir :
1. accélération du rythme et de l’importance des faillites de sociétés financières aux Etats-Unis : de une par semaine aujourd’hui à une par jour en Avril
2. hausse spectaculaire des saisies immobilières américaines : 5 millions d’Américains jetés à la rue
3. effondrement accéléré des prix de l’immobilier US : - 25%
4. entrée en récession de l’économie US en Avril 2007
5. baisse précipitée des taux de la Réserve fédérale US
6. montée en puissance du conflit commercial Chine-USA
7. vente chinoise de Dollar US / retournement du Yen carry-trade
8. chute brutale du Dollar US par rapport à l’Euro, au Yuan et au Yen
9. chute de la Livre Sterling.
Dans le numéro de février de GEAB (sur abonnement), l’équipe LEAP/E2020 détaille la nature et l’enchaînement de ces évolutions pour permettre aux acteurs concernés d’anticiper les conséquences de cette accélération des évènements, qu’ils soient opérateurs sur les marchés monétaires ou financiers, investisseurs, opérateurs commerciaux internationaux, décideurs politiques ou économiques, ou analystes. La stratégie c’est d’abord la maîtrise du temps ! Et dans ce numéro du GEAB, c’est un instrument d’aide à la maîtrise des évolutions du trimestre à venir que nos équipes se sont efforcées de construire.
L’équipe LEAP/E2020 présente dans ce communiqué public une de ces neuf conséquences directes qui sont par ailleurs développées dans le GEAB N°12 (sur abonnement), Ã savoir :
Hausse spectaculaire des saisies immobilières américaines dès le Printemps 2007: dix millions de citoyens US jetés à la rue dans l’année en cours
En effet, après une hausse de 42%, les saisies immobilières en 2006 aux Etats-Unis touchent désormais en moyenne 1 foyer américain sur 92. Des régions entières comme le Colorado, la Californie, l’Ohio, le Texas atteignent des taux d’un foyer sur 35 ou 40, victime de saisie immobilière. Dans l’Ohio, entre Octobre et Décembre 2006, ce sont 3,3% des maisons et appartements qui ont été saisis (1). On assiste a une accélération du processus de saisie du fait de l’insolvabilité d’un nombre croissant de ménages US (cf. GEAB N°10 sur cette question de l’insolvabilité) : en 2006, ce sont plus de 1,2 millions de saisies immobilières qui ont été effectuées (2) touchant directement entre 4 à 5 millions de citoyens américains (en comptant entre 3 et 4 personnes par foyer).”
I’ll post the link to an english translation in few days, when they make it avalable
Selling cows to buy milk.
I like that headline. That’s what Daimler thought when they bought Chrylser. That didn’t work out so well now did it? At least for Daimler shareholders… Same with California real estate when the Japanese were purchasers. And other examples too numerous to mention. If only we could get big dollar holders interested in Florida real estate…
Cassandra,
The question is not who’s selling yen calls, etc, but who’s buying - and why.
It seems obvious. You buy an instrument that promises to pay off big in the case of a tail event. Your goal is to recapture the enormous losses your strategy will incur in the case of that event.
But why should you assume that, in the case of such an event, your ticket will pay up?
Consider the chance of the Sun going supernova. If future performance reflects past results, a very unlikely event. But not impossible at all.
I can sell all the supernova insurance I want. I have no worries in this regard. But why would you buy this instrument?
Yet people, smart people, scoop up these options and model their chance of redemption at 100%. This can only be explained by official action - and more specifically, by a faith on the part of the buyers in official action. It means that the buyers are confident that official actors will use their power of the press to either prevent the tail event, or bail out the option sellers.
As I’ve said many times, this is fractional-reserve banking in a nutshell. It survives only because there is no politically painless way to shut it down. Its only net effect is to funnel the logical equivalent of tax dollars to fat cats in Connecticut.
GAB — aren’t you proposing to sell a dead cow to someone who wants milk?
You put on a large leveraged yen-funded carry trade. Even if the BOJ raises rates by 25 bps, you can still earn a lot of carry. The only thing that can spoil it for you is if the yen rises dramatically. But guess what - you can buy out-of-the-money (OTM) call options on the yen cheaply enough to protect yourself against such eventuality, and still make money on the carry… That’s the closest thing to a ‘free lunch’ that you can get… The question is: who is selling all this OTM option protection at such cheap prices, and how are they hedging themselves? I guess that it the real crux of Cassandra’s question…
yes — that is the key question. the tett article in the FT left the “who is selling” question unanswered, even tho it hinted that lots of the big boys had insurance against a blow up on that leg of the carry trade. Presumably you can:
borrow yen
buy an OTM call on yen
buy real denominated debt and set its coupon/ the appreciation
buy insurance v default on Brazil’s $ bonds (NOT insurance v. move in the real tho — this is a proxy)
and still make money …. I haven’t done the math, but that structure theoretically provides protection on both legs — the OTM hedges v a big move in the yen, and the holding CDS protection theoretically hedges v a big move in the real … if past correlations between the real and Brazil’s dollar bond credit spreads hold.
Brad - my larger point was this. I wouldn’t worry overly about Americans selling the “cow.” Whether they’re selling the “cows” to foreigners or to other Americans, they usually have pretty good timing.
For example, I was taken out of Kerr McGee by Anadarko about a month before oil peaked. Not real good timing by Anadarko. From a contrarian viewpoint, buyers (especially large corporations) tend to have awful timing. By the time they decide to make a purchase, and get everyone on board with the decision, the trend is usually quite mature, thus almost insuring they buy the highs.
“However, in exchange for losing one of the world’s preeminent mining companies to Australia, Americans would only be compensated by the return of their paper dollars.”
(koteli)
dave chiang - do you follow that yet ? fiat dollars are not free money, they are free credit. write that out one hundred times . . .
Moldbug do you have your own blog?
Anon, I’m afraid leeching off of Brad’s audience is so much easier than building my own. One of these days…
guest — true (bad timing of foreign investors), and that has helped the US. but isn’t the bigger issue that the US is now in a position where it has to sell an awful lot of cows over time to finance its ongoing deficits during a period of adjustment?
The translation of that Leap2020 report is already available. It appears to have been published simultaneously.
Dear Cassandra, Brad and Andrew:
If you do a yen carry trade you CANNOT hedge your yen FX risk 100% by just buying a yen call option and still make the carry return because the premium paid will just eat into your carry spread down to zero or become negative when you include costs. Market arbitrage always drives risk-free strategy spreads to zero over benchmark risk-free rates of return. There is no such thing as a free lunch in finance. If there is a “lunch” there has to be a cost somewhere: on the credit, price, or duration sides.
For example: if you buy an out of the money yen call you are not hedging but you are just giving up some of your profit in order to cap your loss.
I shall revert with facts when bank dealing rooms open after the weekend.
Regards.
“…traders said a big drop in foreign demand for Treasuries in December appeared to be attributable to hedge funds, with falls in purchases that originated in the Caribbean and popular offshore domiciles…” http://www.ft.com/cms/s/d50564cc-bd63-11db-b5bd-0000779e2340.html
“…U.S. hedge funds shoulder two-thirds or so of worldwide margin debt, or something in the neighborhood of $300 billion. Truly staggering, furthermore, is the Dresdner Kleinwort estimate that hedge funds account for between 25% and 60% of the trading in global major markets. And, we’re reminded, it’s the marginal trader that makes the market…” http://biz.yahoo.com/seekingalpha/070212/26744_id.html?.v=1
speaking of tett, acquisitions and players of uncertain origin and purpose, this from Friday’s FT:
“… a company has about as much chance of knowing how many CDSs are in the market - or who holds them - as a manufacturer has of tracking a Shanghai counterfeiter who is knocking off cheap shoes. But the issue is starting to look a lot more complicated for corporate executives. What a CDS contract in effect does is protect against non-payment on a corporate bond. However, these derivatives have value only if there is a tangible bond somewhere in the system to underpin them - no matter how small it might be… in a host of recent takeover situations, the acquiring company - be that a private equity group or a trade buyer - suddenly threatens to buy out the outstanding debt, in effect “orphaning” the CDS, to use trader speak…” http://www.ft.com/cms/s/fa1f839c-bd5d-11db-b5bd-0000779e2340.html
Hellasious, that’s not strictly speaking true. In this case OTM calls are priced such that there is a trade in most, if not all reasonable, yen/$ states. The “free lunch” is being paid for by FCBs who are in effect trading away standard of living now for standard of living in the future.
Guest’s FT article raises in one’s minds some interesting possible scenarios. There could be serious legal wrangling in the unwinding of some of this as where “the buck stops” becomes a matter of some opacity. CDSs are an interesting example of this. I’m reminded of Buffett’s experience trying to unwind General Re.
Hellasious — doesn’t it depend on what said of currency pairs you use? Say you borrow in yen and buy relatively cheap insurance on a big move in the yen dollar but then go long Brazil (local currency debt/ equities)? Or borrow yen. buy insurance for a move v. the euro and go long Iceland (local currency debt/ equities)? Now maybe it doesn’t make sense to do this rather than say in the first instance borrow in dollars and go long Brazil and in the second borrow euros and go long Brazil? But then again maybe you are only really worried about really big moves in the yen, and you can buy insurance against those really big moves (small moves against you can manage) relatively cheaply in the big currency markets (low past volatility = low expected future volatility)
Or perhaps another point — suppose you are willing to accept some risk for some return, but want protection against really big losses … I presume you can buy insurance against say a 20% or bigger rise in the yen against the dollar — in that scenario, you win if the carry trade performs better than the cost of your insurance (whether b/c of int. rate differentials or b/c the yen depreciates v the $), and since you are paying for a bit of insurance, that means you don’t do as well as someone who is out there naked but you are protected against a big fat tail kind of loss. your losses are capped at 20% - the carry - the cost of the insurance. I am not a trader so I may have this off — but i would think these kinds of plays might be what people are talking about.
but I am happy to be corrected.
having just received the following notice - and I know nothing about this market - but wondering if, in part, it may respond to one of the issues raised in this post:
“Covered bonds offer triple-A ratings and greater yield than agency and government bonds. With an outstanding amount of nearly EURO 1.8 trillion at the end of 2005 they represent Europe’s largest private bond market. Now Covered Bonds are coming to the US!…” http://www.euromoneyconferences.com/events/event.asp?EventID=286
Dear Brad,
Accepting a 20% risk is, of course, the price of the lunch….
Sometimes the price of lunch is more reasonable and sometimes it’s not, but the price is never zero.
Let’s say I put on a one year yen/dollar carry trade with a net spread of 5% in my favor. A one year yen call with a strike equivalent to my forward yen FX rate, resulting in a perfect hedge, should cost me around 5% and probably even more, to account for volatility and depending on the option type (i.e. American style or European).
If that call is OTC and priced much below 5%, then I have to worry about counter-party credit risk, i.e. the ability of the seller to perform per the option contract. If I manage to convince DumbBank to give me $5 million for a one year ATM yen call against my Hellasious promise, well, then that bank is aptly named and has paid for MY lunch. This is happening ALOT these days with hedge funds, by the way…
In reality the yen carry trade is mostly based on an “implied” call being “sold” by the BOJ in the form of the market’s perception that the central bank won’t raise rates and/or allow the yen to rise.
Watch out, because when such perceptions become widespread they have a nasty tendency to be proven illusory. Even “hard pegs” come unravelled regularly (sterling, Argentine peso, etc.), never mind the soft, implied ones that bounce around speculators’ heads.
Dear Hellasious,
You are right, of course - but I don’t think anyone’s claiming that it is a completely ‘free lunch’… I did say in my previous post that it’s ‘as close to a free lunch as one can get…’ Below is from the FT as of 1 February 2007:
———————————————————–
From Dr Vineer Bhansali.
Sir, I read your two articles on the yen carry trade (January 31) with interest. Concerns that a shift in the dollar’s exchange rate against the yen could trigger a debacle along the lines of Long Term Capital Management’s near-collapse are not new, and have been expressed in one form or another for the last three years - which, as you point out, have been periods of fat profits for many hedge funds. The arithmetic of the carry trade was also laid out by Thomas Stolper at Goldman Sachs, whom you quote as saying that “an implicit but critical assumption for most carry traders was that the low-yielding currency appreciated significantly less than the interest rate differential”. The threat of verbal intervention by the Group of Seven also looms.
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However, these fears ignore the key calculus of risk for the carry positions. At no time in the recent past have option premiums for buying protection on the US dollar-yen, or US dollar-Australian dollar, been so inexpensive relative to the carry returns offered. In other words, while not an arbitrage, the likelihood is high that if you buy the higher-yielding currency financed with the lower-yielding one, and buy protection against the tail risk of an unwind as in the LTCM crisis, you will be safe in most probable outcomes.
The simple reason for this unique state of affairs - low volatility and high carry pairs - is due to an “invisible hand” collusion between sellers of exchange rate volatility via options (”everyone” is selling options as a means to generate income in their portfolios, including many developing central banks) and the authorities, which are setting transparent, low inflation rate policies. The two continue to feed off each other. Nothing short of a crisis of confidence can shake this fearful yet stable equilibrium. Waiting for that crisis, unfortunately, is unprofitable and, given the cheapness of protection against the tail risks, not the course of action you should expect most profit-driven speculators to follow.
Vineer Bhansali,
Portfolio Manager,
Executive Vice President,
Pimco,
Newport Beach, CA 92660 US
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Rozanov
Andrew, Do you reckon that Mr Bhansali’s excellent point an indication of the market’s complacency with respect to risk (i.e. it IS seeen as a one way trade and there are no shortage of insurance grantors) or do you believe that perhaps there is some “official” supply of protection, either directly or indirectly that has so compressed implieds, contributing to the free lunch??
Indeed Yen Option implied vols apppear low in an historical context, using round numbers, currently averages at about 7%, though there IS a wicked skew with the OTM Yen calls decidedly more expensive. The market apparently knows the meaning of lognormal, at least in respect of which direction one is more likely to wake up one fine day and find a meaningfully outsized (and probably discontinuous) move. By comparison, Yen implieds vsd USD had spiked up thorugh 11% back in April/May and 9++% in Nov. Despite the 3 yen correction of the past two days, average implieds barely budged off their lows of near 7 (all at least according to Bloomberg ). I would imagine that OTM has increased in price more than the average. I am sure that Mr Rozanov can put real prices on the implieds to give a picture of what one is paying in money terms, and how this decrements the profitability of various trades.
Hellasious,
I find your comments about counterparty risk extremely interesting and wonder if you’d answer a couple of questions.
First, you write: “If that call is OTC and priced much below 5%, then I have to worry about counter-party credit risk, i.e. the ability of the seller to perform per the option contract.”
Now, at least to a poor moldbug who would never dream of managing anyone else’s money and keeps all his own in little hunks of brightly colored metal, this is a fascinating comment.
My perhaps naive impression had been that the purpose of a financial system was not to “worry about” risk, but to price it. If someone offers me a piece of paper that promises some payment in future, under some conditions, the first thing I want to do is go on the Internet and find out what that paper trades at. This implies a liquid market for notes identical to this instrument, from which I can compute the probability of default.
My impression is that for notes such as these tail event options, no such market exists. Rather, people just assume the option will pay off, and if they “worry about” counterparty risk the only action they take on account of this is to try and spread their counterparties around a bunch.
To be more precise, here is my impression of how the market for these options works. Suppose hedge fund X wants to buy an OTM yen option, to protect its carry trades, and hedge fund Y wants to sell an OTM yen option, because it wants the money.
My understanding is that it is fairly rare, if not in fact unheard of, for Y to simply write the option and sell it directly to X. Instead, Y writes the option and sells it to some bank B. B, rather than simply acting as a distributor and reselling Y’s option, writes its own and sells it to X.
The result is that everyone gets what they want. Y gets nice crisp green bills. X gets an option that is written not by a hedge fund (not a class of entity famous for its longevity), but by a bank. Banks, especially big banks, tend not to fail, and if you want to be extra careful you can spread your counterparties around as many banks as you like. B gets books that look balanced - it has no naked shorts or longs - and it presumably makes a nice vig on the deal.
Is this an accurate depiction of what’s going on? If it’s not, I hope one of the hotshot traders out there will correct me.
If it is, I have to quarrel with the claim that “If that call is OTC and priced much below 5%, then I have to worry about counter-party credit risk, i.e. the ability of the seller to perform per the option contract.”
This is a very interesting statement. Because it asserts that (a) there is no free lunch, and (b) if there is a free lunch, probably someone is selling you fake lunchmeat.
This statement would certainly be true in a closed-loop financial system in which the quantity of money was fixed. It would also be true if X and Y were dealing directly, and X had to mark to market the value of the option sold by Y, according to its own or the market’s assessment of Y’s financial viability.
With B in the loop, however, it strikes me as entirely untrue. It is well known that banks create money by using their official backing to support risks that no purely private actor could sustain. The function of B in this transaction is to conceal any information about the financial condition of Y. This is what (fractional-reserve) banks do - they issue fixed obligations against a pool of assets whose market value fluctuates.
And as usual with banks, the only bound on this money-printing machine seems to be the ability of the bank to persuade its regulators that it should be allowed to accept this risk. If regulators approve, the bank can short volatility all the way down to zero - a sort of black hole of volatility, a financial singularity - and then ask for its bailout when the sun blows up, on the grounds that it has complied with all the relevant directives.
Moreover, the authorities are trapped in a political corner by this strategy - they are damned if they do and damned if they don’t. Any attempt to unwind this system of trades will cause it to explode, with nontrivial political damage. But its continuation threatens the political legitimacy of the entire financial system, because it is more and more clearly a device for enriching the rich at the expense of everyone else.
Obviously, this is the same argument that Vineer Bhansali is making, just with a slight Austrian flavor. If anyone can refute it, I would be greatly indebted to them.
Off topic, but wishing everyone a happy new year on this long weekend.
this might be pertinent and of interesting, especially the vol-related comments
INTERVIEW-Freddie Mac sees Asia expanding dollar debt holdings
TOKYO, Feb 16 (Reuters) - Asian investors including central banks are likely to stay large buyers of U.S. bonds but face challenges as fresh issuance from the U.S. Treasury and mortgage financing agencies remains limited, a senior officer of Freddie Mac said on Friday.
Patricia Cook, executive vice president of investments and capital markets at the No.2 U.S. home funding company, told Reuters her visits to Beijing, Hong Kong and Tokyo this week showed that the hunger for U.S. fixed-income securities is as strong as ever.
“I don’t think that’s going to change in the short term or even in the medium term,” she said, calling Asia a “well-diversified and increasingly important investor base for Freddie Mac”…..
Federal Reserve data shows central bank holdings of agency bonds have more than doubled in the past two years to stand near $600 billion at the end of 2006 — despite persistent worries of central banks slashing their dollar reserves.
China’s world-topping foreign reserves stand at a massive $1.07 trillion and swelled by nearly $250 billion last year from its huge trade surpluses, while Japan’s earnings on its reserves have pushed its total more than $895 billion.
Cook said the sizable purchases of dollar bonds likely mean that many of the trends that have dominated capital markets in the past few years will likely remain in place.
They include low volatility, relatively low interest rates, tight spreads on mortgage-backed securities (MBS) over U.S. Treasuries, and a flat yield curve where long-term yields stay near the levels of short-term yields.
“There is not a lot of anxiety the current environment is going to change,” Cook said.
Investors in Asia are also turning to alternatives to regular bonds as a way of squeezing out yield, such as Freddie Mac’s callable bonds and range-accrual notes.
Range-accrual notes allow an investor to secure a higher coupon, mainly by using derivatives to make a bet that long-term interest rates will remain in a wide band — such as between 1 and 8 percent — and volatility will stay low.
Andrew, moldbug
We agree there is no free lunch. Moving on..
The price of protection against volatility has come down to such cheap levels that analysts are compelled to explain it. The reason for such a “sale” going on is that volatility itself is down to historically low levels, in just about every market you can name. It’s not the premium that is cheap - it’s the volatility that is very low. Therefore, the insurance premium for protecting against its rise is also very low, in the premise that “the trend is your friend”.
PIMCO’s analysis is correct in laying out the facts on the ground, but does not attempt to explain this state of affairs, i.e. why are volatilities and premiums at such record-low levels?
Herein lies the key, in my opinion: the global financial structure currently creating low volatilities and premiums is by ITSELF the risk.
In plainer terms: if you construct an office tower with shallow foundations and shoddy materials and then set the leasing agent’s bonus solely as a percentage of the rent agreements, what do you think will happen? The tower will fill up immediately with bargain hunters, the agent will make a killing on the bonuses and everyone will be happy until an earthquake hits. What then?
1. The builder will roll out his statistical analysis that proves the quake should not have happened.
2. The agent will be on a tropical island spending the bonuses he had already collected.
3. The tenants will be screaming bloody murder, but they are not blameless, either - they should have known something was amiss since their rents were so cheap.
4. The authorities will arrive last: they will blame everyone but themselves, sue everyone they can, send a few people to jail and pass laws “a posteriori”.
…………
On to counter-party risk. Moldbug, you understand the system well; if such OTC transactions were limited to trading between large, financially strong institutions there would be no serious systemic problem. However, the risk resides in balancing the position books in qualitative terms, not quantitative. It is INSIDE the banks that counter-party risk resides, not outside. Their risk exposure is to their customers, not to the market in general.
Look, gentlemen, it all boils down to this:
Anyone can make money for a while by selling insurance cheaply, particularly if by doing so he also creates the illusion that the insured event is less likely to happen. But this is an absurdity, is it not? The low price of insurance does not BY ITSELF reduce risk, yet this is how things stand now, in the minds of speculators. They are deluding themselves that they have somehow discovered the perfect, self-sustaining positive feedback loop.
Are you gentlemen music fans, Johann Strauss in particular? Because…
“Perpetuum Mobile” is great when played by the Vienna Philharmonic on New Year’s Day, but otherwise it does not exist.
Regards
“…Servicing hedge funds is one of the fastest-growing businesses on Wall Street. Called prime brokerage, these activities — which include finding and lending stock to allow hedge funds to sell short… structuring derivatives and executing swaps — account for about $8 billion in annual revenue… the judge overseeing the bankruptcy, Burton R. Lifland, said that Bear Stearns, which made $2.4 million in profits from executing transactions for the fund, “failed to act diligently in a timely manner,” noting that individuals inside the investment bank may have been aware of the fraud dating back to 1998…” http://www.nytimes.com/2007/02/16/business/16hedge.html?ref=business
“…many market analysts said foreign demand was likely to return to normal levels next month. “The sharp drop in US bonds is a little bit startling and notable, but we’re not overly concerned by one month’s data, as this may have been year-end settlement by hedge funds,” a currency trader said. The Treasury Department emphasised the volatile history of the monthly data…” http://www.ft.com/cms/s/d50564cc-bd63-11db-b5bd-0000779e2340.html
Brad–This time, discussions have been facinating, though somewhat technical. I tend to agree with Hellacious. Even if there is some sort of collusion or implicit guarantee by the BoJ or PBoC, eventually, these would be reflected in the market (nothing would and could be out of market).
Since the Japanese economy recorded 4.8% growth in the 4th quater, and the BoJ is likely raise the short-term interest rate this week, the yen may start to rise significantly. Suppose the yen appreciates to 110 yen to the dollar, what would happen? A lot of hedge funds would collapse? Big banks could also suffer?
USDJPY at 110? for one thing, hedge funds collapse all the time without being noticed. the most startling aspect about the paranoia surrounding the weak yen/yen carry trade is how often there have been shake-outs and yet the trend persists. in dec/jan of 2005/06 USDJPY went from 121.40 to 113.40 — with hardly a ripple across markets. i still think the 118.90/108.90 slide in april/may last year contributed to the broad retrenchment in riskier markets globally as volatility and implied vols spiked. but i think that’s where lessons were learned. vols were bought at the lows to hedge short yen positions, especially as implied vols reached decade lows last october (as discussed abundantly above…and despite the noise from europe, people don’t seem to realize the yen weakness has been painstakingly slow and far from volatile, hence the meek implied vols until recently). maybe if we got down to 105 or 100. but that’s where the wall of money waiting to leave japan plays a role. there’s a lot of money — be it retail FX traders, margin traders, retirees wanting foreign assets or uridashi bonds — that simply waits for those pull-backs to 110/115 to buy foreign currencies. that puts a floor under the carry trade. and can japan or even the BOJ (who ironically was blamed for causing the sell-off in risk assets last may/june with the end of quantitative easing last year, and now is blamed for feeding bubbles in those assets) be blamed for that? the story implicit/explicit in what’s happened in japan the past decade that’s accelerated the past few years, and in the dec TIC data, is that investors are losing their home bias in a big way.
as some have pointed out already, americans investing in foreign equities is by no means a new trend. and in fact may have played a big role in the dollar’s slide over the past five years even more than the deficits that china still feels the need to fund.
did you guys read that
GOURINCHAS P-O., REY H. (Princeton)
From World Banker to World Venture Capitalist: US External Adjustment and the Exorbitant Privilege
http://www.cepremap.ens.fr/depot/docweb/docweb0606.pdf
tmcgee — interesting. but I would argue that the “buying on the dips” phenomenon is a product, in part, of expectations that there is a price where the MoF gets back into the market … ergo, your downside risk is limited.
There certainly was a time when lots of folks were betting that the yen would rise substantially from 105 or so … but that was also a time when US rates were low.
what is interesting, at least to me, is that the end of low US rates reduced Japan’s need to intervene, as private Japanese savers suddently discovered the joys of financial globalization (and generally, speaking, have done well out of it … there hasn’t been a really really nast correction; the instances you note are not 98 like …). but it hasn’t in any way ended the need for most emerging economies to intervene.
Hellasious,
Thanks - I feel like my mapping of modern financial engineering to the basically 19th-century Austrian framework has improved a little.
The problem, as usual, is the banks. “Large, financially strong institution” is not an accurate description of these companies. It may be better to think of them as branded government agencies. Certainly, if their official protection were withdrawn, their liabilities would trade at a considerable discount.
In a free-market financial system there is no agent who can make promises whose reliability is not discounted by the market. When you introduce such agents into the system, and back them with the power of the printing press, you have to regulate them. Otherwise you might as well give them their own laser printer and a PDF of Mr. Franklin.
If Ricardo and the British Currency School had realized in the 1820s that the liabilities of a politically protected bank are money, we would not have these problems. Later economists did realize this, and it’s now conventional to think of demand deposits as part of the money supply (M1).
A demand deposit is a simple promise to pay a constant amount. What banks are doing now is writing an enormous volume of much more complex instruments. But they are still protected by the same political insurance. And they are still creating money.
Because there is still such a thing as bank regulation, the banks do not write naked options - just as they do not create naked demand deposits. They back these instruments by a pool of assets which are obligations issued by other agents - some banks, most not.
Many of these bank assets are promises made by hedge funds. Since hedge funds blow up all the time, and since they are not renowned for their transparency, in the absence of a protected banking system, these promises would be very hard to price. The banks can “launder” them and issue new promises, which other hedge funds can buy and treat as if they were government promises, only because of their official backing.
Obviously, this problem wouldn’t exist in a free-market financial system. But it does exist, and there is only one solution for it: more regulation. It is not really possible for regulation to replicate the stability or efficiency of a free market, but there is certainly such a thing as doing worse or doing better.
Regulating hedge funds, thereby going down the path of turning them into banks, is not the right approach. The problem is the banks themselves. I am the furthest possible thing from a regulatory expert, but there has to be some way to stop banks from buying these dodgy promises, or at least from using them to to sell an apparently infinite supply of short volatility.
Of course this is a mild version of my preferred approach, which is to nationalize all banks, convert their liabilities to present money at the current market value, and fix the quantity of money. If this happens all my mold will be pretty much worthless. Fortunately or unfortunately, depending on your point of view, it seems unlikely…
There was a big selloff in treasuries in December and January and interest rates rose. Maybe it’s not coincidental that we saw outflows. Now we’re seeing treasuries rally again. It’s hard for me to think the US gov’t isn’t having it’s debt financed if treasury yields are falling.
tmcgee,
While in general yours was a very interesting and informative post, I do need to take umbrage with “and can Japan or even the BOJ … be blamed for that?”
Yes, they can, because the low interest rates they set creates the voltage differential which makes it profitable to move savings out of Japan.
I’m sure they are not doing this out of malice. I’d guess that they have perfectly good political reasons for their actions, and they have selected not an option that is perfect, but an option that they believe is the best available.
So in this sense, no, they cannot be “blamed” for the flow of private savings out of Japan. But their actions certainly do affect that flow.
very interesting
(sorry for my english level)
what’s scaring me is that everything is made to sustain the dollar and it’s still falling.
- high hedges funds activities with foreins corps and securities
- constant raising of fed rates since 2004 (bernanke said stop)
- very low prices to sustain consumption (thx to wallmart)
- high reserve of dollars outside the country
- and what L.H Summers calls a “financial balance of terror” to assure continued financial flows with huge contracts
and every parameter is reaching is limit
a 10%-20% ajustement is comming
but no one want’s to see the dollar fall so we are
juggling with a massive amount of cash. This money is injected in commodities and here comes the first consequence : a heavy risk of inflation in countries like China, india, south korea and especially russia.
I’am far from a specialist but that’s how i see the deal
Could this be the sign I was asking for in the last thread on globalisation of finance ?
a 10%-20% ajustement is comming
or more…