The Rise of Carry By Tim Lee, Jamie Lee & Kevin Coldiron Presentation to CQF Institute, August 2020 Agenda 2020 August
• Characteristics of Carry and the Carry Regime.
• Why the March 2020 crash would have happened anyway.
• Possible paths from here.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 2 Characteristics of Carry Trades 2020 August
1. Leveraged
2. Liquidity Providing
3. Short Volatility
4. ‘Saw Tooth’ Return Pattern
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 3 Features of Carry Regime 2020 August
1. Promote unsustainable rates of debt & economic growth. 2. Deflation occurs via shocks. 3. Financial assets seem like attractive cash substitutes. 4. S&P 500 is a carry trade.
5. Central bank capture.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 4
Debt & Credit Growth August 2020 August Examples of EM Carry Trades 1. Classic currency forward trade to exploit short-term rate differential. 2. Short-term US$ borrowing to invest in higher-yielding EM local currency corporate bond. 3. EM corporate issues US$ debt to fund local currency real investment or to on-lend proceeds to other companies.
Willingness to accept or ignore currency risk allows
more debt/credit growth than otherwise would happen.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 5 Moneyness & Deflation 2020 August
G7 Debt & Real Growth Private & Public Debt / GDP (Left Axis) Avg. GDP Growth, Last 10 Years The carry regime is 300% 6.0% fundamentally deflationary. 250% 5.0%
Why? 200% 4.0% It exists in an environment 150% 3.0% of burdensome debt, limited 100% 2.0% growth and low RoI. 50% 1.0%
0% 0.0%
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron Source: IMF Global Debt Database, Our Calculations 6
Moneyness & Deflation: August 2020 August Carry Regime Deflation Occurs as a Shock
Carry Crash: • Volatility spikes ➔ “Money-like” assets suddenly appear risky. • Demand for true cash rises sharply ➔ Correlations go to 1 across markets. ➔ Example: March 10th – 18th 2020 • Money supply suddenly appears deficient, inflation rate can
quickly become negative.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 7
Moneyness & Deflation August 2020 August Stylized Example & Evidence
Cumulative Net Purchases/Sales: US Nonfinancial Corporates Debt • US corporates sell debt 6 perceived as good substitute for money. 4 2 0
$ Trillion $ -2 -4
-6
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron
2012 2006 2007 2008 2009 2010 2011 2013 2014 2015 2016 2017 2018 2019 Source: Federal Reserve Board, Our Calculations 8
Moneyness & Deflation August 2020 August Stylized Example & Evidence
Cumulative Net Purchases/Sales: US Nonfinancial Corporates Equity Debt • Increased debt helps 6 finance stock buybacks. 4 2 0
$ Trillion $ -2 -4
-6
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron
2012 2006 2007 2008 2009 2010 2011 2013 2014 2015 2016 2017 2018 2019 Source: Federal Reserve Board, Our Calculations 9
Moneyness & Deflation August 2020 August Stylized Example & Evidence
Net Purchases of US Equities (2006-2019, $ Billion) 800 • Public swaps equity for 600 debt, which is perceived 400 200
as money-like. 0
-200
-400
-600
-800 Coldiron Non-Financial Companies Kevin Lee, Jamie Lee, Tim Carry: of Rise The
Source: Federal Reserve Board, Our Calculations Source: Federal Reserve Board, Our Calculations 10
Moneyness & Deflation August 2020 August Stylized Example & Evidence
Net Purchases of US Equities (2006-2019, $ Billion) 800 600 • Public swaps equity for 400 debt, which is perceived 200 as money-like. 0 -200 -400 -600 -800
Non-Financial Companies Household + Pension + Coldiron ETF/Mutual Funds Kevin Lee, Jamie Lee, Tim Carry: of Rise The
Source: Federal Reserve Board, Our Calculations Source: Federal Reserve Board, Our Calculations 11
Moneyness & Deflation August 2020 August Implications
• Satisfies demand to hold “money” and earn yield. • But escalates the potential severity of a carry crash, when only true money suffices. • Companies become like banks, levered entities with
monetary liabilities.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 12 Central Role of S&P 500 2020 August S&P500 Vol Represents Generic Liquidity Risk
• Global risk assets increasingly integrated with S&P 500.
• S&P500 derivatives & ETFs are the most liquid venues for equity risk in the world.
• S&P500 can thus be used to hedge risk in a wide variety of less liquid instruments.
• S&P500 absorbs both the liquidity demands and liquidity
premium from these markets.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 13
Carry Regime: August 2020 August Central Role of S&P 500
• Correlation of global markets with S&P 500 increased steadily (until the GFC)
Median Adjusted R^2 by Group Local Real Retn = α + β1(S&P Up) + β2(S&P Down), 10-Year Windows
70% 60% 50% 40% 30% Developed 20% Emerging 10%
0% Coldiron 1980 1985 1990 1995 2000 2005 2010 2015 2020 Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: MSCI, Global Financial Data, our calculations 14
Carry Regime: August 2020 August Central Role of S&P 500
• US has largest and most liquid equity markets – China is second, but not fully integrated with global financial markets
Value of Shares Traded as % of World Shares Traded (2019) 45% 40% 35% 30% 25% 20% 15% 10% 5%
0% Coldiron United States China Japan EU (2014) Korea Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: World Bank, our calculations 15
Carry Regime: August 2020 August Central Role of S&P 500
• US has largest and most liquid equity futures markets by far
Major Futures, Notional Value Traded (2018, $ Billion) 70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
E-mini S&P 500 E-mini Euro Stoxx 50 E-mini DOW Mini Nikkei 225 KOSPI 200 All Chinese
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron NASDAQ 100 financial futures Source: World Federation of Exchanges, China Futures Association, CME 16
Carry Regime: August 2020 August Central Role of S&P 500
• Even in the deepest and most liquid market, S&P500 instruments stand out
Value Traded as % of World Shares Traded (2019) 45% 40% 35% 30% 25% 20% 15% 10% 5%
0% Coldiron United States China Japan EU (2014) Korea SPY Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: World Bank, Yahoo! Finance, our calculations 17
Carry Regime: August 2020 August Central Role of S&P 500
• S&P500 instruments are the center, the focus, the fulcrum of global risk markets
Value Traded as % of World Shares Traded (2019) 90% 80% 70% 60% 50% 40% 30% 20% 10%
0% Coldiron United States China Japan EU (2014) Korea SPY ES Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: World Bank, Yahoo! Finance, CME, our calculations 18
Carry Regime: August 2020 August Central Role of S&P 500
• As a result: volatility selling is most profitable on the S&P 500
PutWrite Indices (adjusted to 1% daily volatility) 300
Sharpe: 0.36 250
200 Sharpe: 0.26 150 Sharpe: 0.07 100
50
0
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron Emerging Markets EAFE S&P 500 Source: CBOE 19
Central Role of S&P 500 August 2020 August S&P500 as the Central Carry Trade
• The price of liquidity – the value of money – is set in the S&P500 markets.
• Absorption of the generic liquidity risk premium converts the S&P500 into an extreme carry trade. Implications:
1. It should command a high premium but have substantial skew. The probability of sudden crashes like 1987, 2008, &
2020 is meaningful. Coldiron 2. Causality flows from the markets to the real economy, not Kevin Lee, Jamie Lee, Tim Carry: of Rise The the other way as we have been taught. 20
Carry Regime: August 2020 August The Fed’s Bind & Capture
• Fed was created to provide liquidity to markets in times of panic.
• If it acts after a market disruption to provide liquidity, markets stabilize and volatility subsides.
• This truncates losses for carry trades and encourages
their growth.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 21
The Fed’s Role: August 2020 August Reinterpreting QE
Conventional view of QE’s impact equities:
1. Lowered bond yields. Expensive absolute equity valuation (CAPE, etc.) seems reasonable on a relative basis.
2. Portfolio rebalancing. Institutions that sold long-term bonds and MBS to Fed reinvested those holdings in corporate bonds
and equities.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 22
The Fed’s Role: August 2020 August Reinterpreting QE
QE through the lens of Carry: The Fed has unlimited ability to provide leverage and liquidity. In doing so it suppresses volatility. With QE the Fed was selling volatility in massive quantities. It acted as a carry trader, reinforcing the most important
carry trade: S&P 500.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 23
Carry Recipients & Crashes: August 2020 August Banks’ Cross-Border Net Claims
Australia Brazil Korea Thailand Turkey 280 240 200 160 120
80 US$ Billions US$ 40 0 -40
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 Coldiron Source: BIS Kevin Lee, Jamie Lee, Tim Carry: of Rise The 24
Carry Recipients & Crashes: August 2020 August Quarterly Changes Highlight Carry Crashes
100
50
0
$ Billion $ -50 LTCM Euro -100 Crisis
GFC -150
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Coldiron Source: BIS Kevin Lee, Jamie Lee, Tim Carry: of Rise The 25 Carry Recipients & Crashes: 2020 August Using Banks in Funding Currencies to Track Currency Carry
Model Based on Dollar, Euro & Yen Funding Bank Net Claims on Major Carry Recipients 2,000 1,800 1,600 1,400 1,200 1,000 800
US$ Billions US$ 600 400 200 0
2002 2004 2006 2008 2010 2012 2014 2016 2018 Coldiron Source: BIS, IMF, our calculations Kevin Lee, Jamie Lee, Tim Carry: of Rise The 26 Carry Recipients & Crashes: 2020 August Fed Replaces Private Dollar-Funded Carry Trade
Fed Liquidity Swaps 800
600
400 US$ Billions US$ 200
0
2008 2010 2012 2014 2016 2018 2020 Coldiron Source: US Federal Reserve Kevin Lee, Jamie Lee, Tim Carry: of Rise The 27 Carry Recipients & Crashes: 2020 August Currency Carry and Volatility
• Currency crashes were each part of a larger volatility-selling crash. VIX 70 60 50 40 30 20 10
0
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 28
Carry Crashes & Deflation: August 2020 August Carry Crashes are Deflation Shocks
US Deflation Shock Indicator • Deflation shock indicator 2.0 attempts to gauge risk of a “dash for cash” 1.5 1.0 • Components: 1. Personal sector financial 0.5 assets. 0.0
2. Bank deposits relative to -0.5 total financial assets. 3. Money supply. -1.0 -1.5
-2.0
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 29
Carry Crashes & Deflation: August 2020 August VIX & Deflation Shocks
• Deflation indicator is VIX (left axis) Deflation shock indicator (inverted) inverted – rising line 60 -0.8 denotes ongoing 50 -0.4
deflation shock. 40 0
• VIX spikes – a jump in 30 0.4 the price of money – is 20 0.8 a deflation shock. 10 1.2
0 1.6
1992 1996 2000 2004 2008 2012 2016 2020
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 30
Deflation: August 2020 August Carry Crash Was Inevitable
Global Real Interest Rate & Trend • Carry crash would have 6.0
happened even without 5.0 coronavirus. 4.0
3.0 • Fall in global real rates indicates declining 2.0 global growth and 1.0
demand for credit. 0.0
-1.0 Coldiron -2.0 Kevin Lee, Jamie Lee, Tim Carry: of Rise The 1987 1992 1997 2002 2007 2012 2017 31
Deflation: August 2020 August Similar Pattern in 2007 and 2011
Advanced Economy Industrial Production Growth (yoy % chg, left axis) Global Real Rate Relative to Trend 16 2.0 12 1.5 8 1.0 4 0.5 0 0.0 -4 -0.5 -8 -1.0 -12 -1.5 -16 -2.0
-20 -2.5
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 32
Central Bank Response August 2020 August Central Banks Expand Their Own Carry Trades
Central Bank Balance Sheets (Indexed to 100 in Jan. 2007) 900 800 700 600 500 Fed 400 ECB 300 200 BoJ 100
0
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 33
Central Bank Response August 2020 August Central Banks Expand Their Own Carry Trades
Annual Growth Rate of Balance Sheets Fed ECB BoJ • Response will likely 180 160 have to surpass 140 GFC if new carry 120 100 bubble is to be 80 created. 60 40 20 0 -20
-40
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron
2011 2008 2009 2010 2012 2013 2014 2015 2016 2017 2018 2019 2020 2007 34 Possible Paths From Here 2020 August
1. Deflation.
2. Renewed Carry Regime.
3. Carry Regime Ends with Inflation.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 35 Indicators to Watch 2020 August
1. Deflation. Long-term US yields deeply negative.
2. Renewed Carry Regime. VIX falls back to low levels, forward vol curve returns to contango and interest rates edge up a little bit initially.
3. Carry Regime Ends. Upward pressure on market interest rates. VIX remains elevated, forward vol in backwardation. Extreme volatility in emerging market currencies and
inversion of the “vol-of-vol” curve.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 36 August 2020 August Market Expecting Deflation…For Now
• Inflation expectations have moved • Yields on both nominal 10-year lower at all horizons. bonds & 10-year TIPS near all- • Inflation premium in long-term time lows. Treasuries also lower.
Inflation Expectations Real Yields 2.5 0.2 Jan. 0.0 2.0 -0.2 1.5 -0.4 -0.6 1.0 Now -0.8 Jan. 0.5 -1.0
-1.2 Coldiron 0.0 Kevin Lee, Jamie Lee, Tim Carry: of Rise The Core CPI 1-Year 10-Year Inflation -1.4 Now Nowcast Expected Expected Risk -1.6 Inflation Inflation Premium 3-Month 1-Year 10-Year 37 Website: Going Live in mid-August 2020 August www.riseofcarry.com
• Carry-related research.
• Data and charts from The Rise of Carry.
• Links to author podcast interviews, book reviews and articles.
• Contact Us:
• [email protected], [email protected], [email protected]
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 38 August 2020 August Appendix: Mechanics of the Liquidity
Trade The Rise of Carry: Tim Lee, Jamie Lee, Kevin Coldiron Kevin Lee, Jamie Lee, Tim Carry: of Rise The 39
Volatility Selling August 2020 August Mechanics of the Liquidity Trade
• The volatility premium is not confined to derivatives markets.
• It expresses itself through trades in – and the price behavior of – the underlying.
• Examples: 1. Levered ETFs. 2. Volatility managed strategies like risk parity.
3. Short strategies.
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 40
Volatility Selling August 2020 August Mechanics of the Liquidity Trade
• The volatility premium can be decomposed into three parts:
1. Implied-Realized Gap
2. Forward Volatility Rolldown
3. Short-Term Mean Reversion
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron 41
Volatility Selling August 2020 August Implied-Realized Gap
• Option-implied volatility has been systematically above realized volatility. This is a risk premium. VIX and S&P 500 Realized Volatility 90 80 70 60 50 40
30 Average VIX: 21.0 20 10 Average Realized: 18.2
0 Coldiron 1990 1995 2000 2005 2010 2015 2020 Kevin Lee, Jamie Lee, Tim Carry: of Rise The VIX Trailing 60d Realized Volatility Source: CBOE 42
Volatility Selling August 2020 August Implied-Realized Gap
• Historically this has been a very high-Sharpe trade, in spite of drawdowns in 2008 and 2020 that each wiped out several years of returns.
S&P 500 Variance Swap Total Return 1.5
1.4 Sharpe: 1.68
1.3
1.2
1.1
1.0 Coldiron 1990 1995 2000 2005 2010 2015 2020 Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: Yahoo! Finance, our calculations 43
Volatility Selling August 2020 August VIX Rolldown
• Forward implied volatility has been systematically above spot implied volatility. This is a risk premium.
VIX Futures Curve (average 2006-2020) 22.0
21.5
21.0
20.5
20.0
19.5
19.0 Coldiron Spot VIX 1m fwd VIX 2m fwd VIX 3m fwd VIX 4m fwd VIX Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: CBOE, our calculations. 44
Volatility Selling August 2020 August VIX Rolldown
• Accordingly, VIX futures have seen significantly negative returns over time.
Constant Maturity 1m VIX Futures Total Return 1,000,000
100,000
10,000
1,000
100
10
1
The Rise of Carry: Tim Lee, Jamie Lee, Kevin Kevin Lee, Jamie Lee, Tim Carry: of Rise The Coldiron Source: Kuchita, Yahoo! Finance 45
Volatility Selling August 2020 August Short-Term Mean Reversion
• Volatility measured over horizons of several days to a month has been systematically below volatility measured daily. This is a risk premium. Ratio of Daily to Monthly Volatility of S&P 500 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2
0.0 Coldiron 1952 1962 1972 1982 1992 2002 2012 Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: Yahoo! Finance, our calculations. 46
Volatility Selling August 2020 August Short-Term Mean Reversion
• Trading strategies synthesizing the difference between daily and longer-horizon variance would have seen positive total returns (before costs) since October 1987. S&P 500 Daily-Monthly Variance Swap Total Return 1.10
1.05
1.00
0.95
0.90 Coldiron 1950 1960 1970 1980 1990 2000 2010 2020 Kevin Lee, Jamie Lee, Tim Carry: of Rise The Source: Yahoo! Finance, our calculations. 47 Mechanics of the LiquidityVolatility SellingTrade 12 14 16 18 20 22 24 26 Instantaneous VIX Realized Implied - 1 Month 1 Day Mean Reversion Mean VIX Rolldown Short 2 Months - 1 Week Term 3 Months 1 Month Momentum 4 Months Long 1 Year ‘Value’ - Term 5 Months 7 Years Implied Realized 48 The Rise of Carry: Tim Lee, Jamie Lee, Kevin August 2020 Coldiron