What history tells us about the carry trade: El-Erian
If there were any remaining doubts about investors' "reach for yield," today's Greek bond news should lift them. This massively oversubscribed offering speaks to a strong market appetite for the first internal bond issuance since 2010 by a sovereign that – only two years ago – imposed significant losses on private bondholders; and it did so without being able to deal decisively with its excessive indebtedness.
The scramble for the new Greek bonds is but the latest indication of a "carry trade" that is back in full force and, as explained here, for understandable reasons. It's a market phenomenon that is likely gain further momentum in the weeks to come as competitive pressures accentuate the opportunity costs of below-carry portfolios.
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As this phase continues to plays out, investors would be well advised to remember four key historical insights:
First, investors' romance with carry trades flourishes in relatively stable economic environments, particularly when interest rate volatility is relatively low. These days, central banks are also acting as matchmakers by repressing risk-free interest rates. (And yesterday's Federal Open Market Committee minutes confirm that the Federal Reserve is committed to this policy approach.)
Second, the impact of these "pull factors" can be turbocharged by an already-compressed level of risk spreads that pushes investors to take more risk and increase leverage – all as a means of targeting unchanged return objectives.
Third, such a combination of pull and push factors can lead investors to overdo the love affair with carry trades – not just by pushing bond prices too high (and, therefore, credit spreads too low) but also by failing to differentiate sufficiently between low- and high-risk holdings (resulting in an excessive flattening of the credit curve).
Fourth, history also reminds us that, when taken to extremes, carry trades can end up delivering quite unpleasant surprises to investors, especially unsuspecting ones.
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With this in mind, here is a short list of past nasty surprises to be aware of and, therefore, guard against:
When the love of affair sours, it usually does so quite abruptly given how crowded carry trades tend to get.
Investors' natural inclination at that stage is to try to quickly get "back on side." This can easily generalize market disruptions, thus impacting quite a large universe of holdings (particularly, investment grade, high yield and emerging markets).
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It's easy for investors to underappreciate the extent to which earned carry can be quickly wiped out by subsequent adverse price moves. While not necessarily an issue for unlevered hold-to-maturity portfolios, it can be quite disruptive for levered positions (especially those facing the risk of fund outflows).
Liquidity can, and does, evaporate quite quickly, making portfolio re-positioning a costly and tricky endeavor. The contrast is particularly stark for recent new issues.
The gathering clouds over the increasingly-crowded carry trade may well have a silver lining, albeit down the road. The eventual unwinding would tend to create very attractive entry points for those both able and willing to act counter-cyclically. If only it were easier to get the timing right.
— By Mohamed El-Erian
Mohamed A. El-Erian, former CEO and co-CIO of PIMCO, is a member of the International Executive Committee at Allianz and chief economic advisor to its management board, chair of the President's Global Development Council, and author of the NYT/WSJ bestseller "When Markets Collide." Follow him on Twitter @elerianm.