One of the strangest things about the volatility that has blinded financial markets is its inevitability.
The only possible trade – and only the most profitable – in a less volatile world is suddenly exposed when “vol” rises. While traders can hold these positions for long periods of time, they are inherently unstable, and finding the right timing consistently is next to impossible.
These wagers include FX “carry trades” – considered by many to be essential in the recently shaken global markets – and so-called “basis” trades in US Treasuries, where hedge funds trade the small price difference between futures and bonds. .
Importantly, the energy required to profit from this arbitrage trade increases the risk – and the pain when the inevitable change comes.
In theory, none of these opportunities should last long if you believe in the efficiency of the free market, and its self-correcting ability to remove arbitrage wrinkles when they arise.
The reality is different, of course.
Limited, speculative bets that exploit interest rates or price differentials can last significantly longer. Witness yen trading. It took years, aided by the decade of “Abenomics” in which Japan deliberately weakened its currency through ultra-loose monetary policy.
There is nothing wrong with this, of course. Financial markets attract participants of all stripes with very different agendas, time horizons and risk tolerance profiles.
But, as we’ve seen recently, high-risk gambles can turn sour in an instant as selling to cover losses and meet margin calls begins to sell more.
Interest rate differential
From a theoretical and fundamental point of view, such trade-offs are often counterintuitive.
Check out the FX exchange. In its simplest form, this involves borrowing cheap money with a low yield and investing in a high yield asset. The trader pockets the interest rate difference and, in theory, the price difference as the loan goes down.
But currencies that offer low returns are relatively low-risk assets backed by strong fundamentals such as current account surpluses. Interest rates are low because inflation is low.
Currencies that offer high interest rates are less attractive. Yields are high to compensate for high or volatile inflation, increased credit risk, or significant political instability. In some cases, all of the above.
Successful carry trading therefore depends on two factors: low volatility – or, more precisely, long periods of below-average volume – and timing. The investor needs to get out of the trade before the inevitable spike in volatility triggers a wave of short covering that blows up the trade.
Time is hard
Finding the right timing in these types of trades is more luck than skill, but even sophisticated investors tend to forget this, especially when volatility remains low for a long period of time.
“The type of carry trade is very skewed – you make a little money but lose quickly,” said Brent Donnelly, president of Spectra Markets.
“It seems too good to be true but it’s too hard to risk. You hope for a fair world with low economic and financial volatility … but when volatility increases you are forced to exit quickly.”
Investors can compromise because large increases in volume, while inevitable, are rare. According to analysts at HSBC, the dollar’s 10% fall against the yen in the past month is below the 0.4th percentile of its historical 20-day exchange rate dating back to 1974. The last time there was a similar big decline was in October. 2008.
The two-year Treasury yield falling 50 basis points in just two days is similarly unusual. This has happened several times in the last 40 years, most notably on Black Monday, after 9/11, and during the global financial crisis in 2008 and the US regional banking shock last year.
The fallout when this trade is going well can be devastating. A “Value At Risk” shock of this level, basically a jump in the maximum loss an investment can sustain over a period of time, can destroy portfolios and depress funds.
In extremes, it could risk creating global financial instability, as was seen when the Long Term Capital Management crashed in 1998.
Part of the problem may be how the “VaR” models are constructed. Many use basic voltage gauges like the S&P 500 “VIX” index as a key input. But such metrics are often artificially suppressed by the perceived hype that fueled these booming trades in the first place. Then they go pop.
While we don’t know how the current episode will play out, it’s safe to say that there will be casualties. Consider that the “core trade” positions in US Treasuries that regulators warned about are now worth more than $1 trillion.
Jonathan Ruffer, chairman of a UK-based fund called Ruffer, wrote on July 11 that performance had been reduced in part because the yen had not recovered as strongly as he had hoped. He lamented the difficulty of measuring the time, but noted that when it did go, it would go “explosively” and give “far, far more than the right amount.”
The yen opened on July 11. It remains to be seen what will turn next.
(The views expressed here are those of the author, a Reuters reporter.)
-Jamie McGeever, Reuters
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