Thin Ice

This is the second or third time I've seen the carry trade discussed lately and it's easily the most accessible version. I thought I'd share the link and an excerpt here. The tagline for the article is "When interest rates rise, don't be surprised how low markets can go."

Government can only issue debt so long as there are willing buyers at reasonable interest rates. This is so far being achieved by the Fed by keeping short-term rates artificially low so that banks and hedge funds can borrow at 25 basis points and use this money to buy treasuries yielding 3.5% to 4%. This is called the carry trade, and it is going on today on a massive scale.

The systemic danger of this carry trade activity is that it is done by institutions that leverage themselves by 10 to 30 times. This means they absolutely cannot afford to have long-term interest rates (which the Fed doesn't control) go up. A rise in rates means the value of their holdings will quickly drop much more than all the interest they have earned on those holdings.

In short, at the first sign interest rates may rise, the carry-trade bubble will burst and everyone will rush to sell.

The article is predicting inflation, not necessarily a massive market collapse, although I've seen that predicted as well. As an aside, one of my ex-favorite bloggers, Mish Shedlock, has been blogging nothing but econodoom for the last year and a half and his followers have missed the entire 2009-10 bull market. What this has taught me is that fundamentals may drive the market in the long run, they don't drive the market in the short to medium run.

Food for thought.