The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis (BUSINESS BOOKS)

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What is a Franken-Bull? It’s a term I came up for a market that has bearish fundamentals, but experiencing a bull run. These characteristics are reflected in the options market on which the VIX is based. As both put and call options provide the same cover against market volatility, the prices of the two exhibit a phenomenon known as “put-call parity,” diverging little from each other. These data show that daily price changes of U.S. equities followed a random walk when measured over the whole span from 1927 to 2020. The actual variance over periods of one to thirty-two days is almost exactly the same as that implied by the daily variance (vari­ance, the square of the standard deviation, is a measure of volatility). Price changes do not, however, show a consistent pattern when measured over shorter time periods: since 1945 there has been a sharp positive serial correlation for one-day changes measured over periods of one to eleven years, but steady negative serial correlation there­after. Yet the authors are correct in claiming that daily price changes have shown a negative serial correlation since 1987.

The financial shelves are filled with books that explain how popular carry trading has become in recent years. But none has revealed just how significant a role it plays in the global economy - until now. The main reason for the surge upwards in the indicator, to unprecedented levels, is the collapse of money supply, with my estimate being that for Q1 M2 will be -2.6% year-on-year, unprecedented in modern history.

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The financial shelves are filled with books that explain how popular carry trading has become in recent years. But none has revealed just how significant a role it plays in the global economy—until now. Financial instability has thus risen as the carry trade has grown. The Rise of Carry does not estimate the size of the market, for which reliable data do not seem to be available, but the authors argue convincingly that it is very large and has expanded greatly in recent years. They also point to the risk that volatility in different financial assets may be contagious: “There is also evidence of a growing correlation between currency and equity market carry, suggesting that a single global volatility risk factor may be a driver of all forms of carry in the future. If this is true, future carry crashes may impact on all asset classes at the same time.” 7

For most of the twentieth century, the neoclassical synthesis in economics was generally believed to provide a solid basis for public policy. There were, nonetheless, significant dissenters. Hyman Minsky, for instance, wrote that “modern orthodox economics is not and cannot be a basis for a serious approach to economic policy.” 1 In the wake of the financial crisis and the great recession of 2008, such questioning became even more vociferous, and criticisms like Min­sky’s are now increasingly accepted. However these issues are all fairly well documented and have been mainstream consciousness for quite a long time. So the book hardly broke any new ground here. But at least they are coherently articulated with no obvious logical fallacies. We are now in the midst of a perpetually moral hazard cycle in that carry traders, having their loses truncated, and walked out of the risk-of-ruin scenario relatively unscathed, they have incentive in ever increasing their prior behavior before, knowing the central banks will rescue them once again when the time comes.If you think easing and tightening at the same time sounds like a contradiction, sounds like a loss of control, I’m with you. Tim Lee is the founder of the independent economics consultancy pi Economics, serving financial institutions from hedge funds to traditional asset managers. Prior to setting up pi Economics in Greenwich, Connecticut, in 2003, he worked in London as European economist and global economic strategist for asset management companies including GT Management and Invesco. Before London, he spent nine years in Hong Kong as an Asian economist for GT Management.

When the music stops, in terms of liquidity things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing. Kevin has an MBA from London Business School and a BSc in Finance from the Pennsylvania State University. Tim Lee Because volatility risk cannot be hedged in aggregate and the total amount insured seems to have grown so much, there is broad agree­ment that a future increase in volatility will produce big winners and big losers. There is, however, no consensus on whether this will simply involve a large-scale exchange of wealth between otherwise equivalent players in the market—the Pauls receiving large sums from the Peters—or if it will have serious economic, political, or social consequences.The financial crash in February-March does not need coronavirus to explain it. It was predictable based on an understanding of the carry regime. But unlike in previous carry crashes, extreme central bank (and government) action has seemed able to rescue the financial markets but this time not necessarily the economy. The carry regime tends to increase inequality and the much more extreme situation we find ourselves in now raises a question mark as to its sustainability. What comes next is uncertain but there are pointers that can provide strong clues to the bigger picture. Tim Lee is the founder of the independent economics consultancy pi Economics, serving financial institutions from hedge funds to traditional asset managers. Previously he worked for global asset managers including GT Management and Invesco in Hong Kong and London. He is the author of the highly regarded Economics for Professional Investors (2nd edition, 1998) and his commentaries and analysis have been widely quoted in the media. Tim was educated at Magdalene College, Cambridge University.