‘Perhaps – Finally – Realistic’: Five Years Later, One Man’s Carry Trade Prophecy Comes True

If you haven’t read it yet, do yourself a favor and peruse “Turkey’s Financial Crisis Surprised Many. Except This Analyst.”

That article, by Landon Thomas Jr. and published in the New York Times on Saturday, tells the somewhat sad story of Tim Lee, described by Thomas as follows:

A soft-spoken Englishman who eschews financial television and social media, Mr. Lee started writing an investment newsletter in 2003 after two decades working as an economist for the British mutual fund company GT Management.

While there will invariably be a chorus of folks who point to the article linked above as evidence of that old adage about how being early is “the same thing as being wrong”, I’d argue that’s something of a misnomer in this case.

As Thomas alludes to in his piece, the tsunami of liquidity unleashed by developed market central banks in the wake of the financial crisis is in large part responsible for facilitating the kinds of imbalances that are now unraveling as that stimulus is rolled back. The mad scramble for yield catalyzed by post-crisis monetary policy sent investors scurrying down the quality ladder, leaving everything priced to perfection. Spreads on risky debt were (and in most cases still are) an illusion. Now that the Fed is tightening and dollar liquidity is disappearing, the carry trade is unwinding and the first casualties are showing up. Turkey is the first domino.

For those interested, there’s a ton of color on this in “Dollar Liquidity Dynamics: An Epochal Shift Is Coming, One Bank Warns“.

The vast majority of U.S. investors (especially of the retail variety) are completely oblivious to this dynamic, which is why they generally don’t care about what’s happening in Turkey or in emerging markets more generally.

That’s a mistake.

What’s lost on most U.S. investors is the extent to which the very same fiscal policies that have allowed U.S. equities to remain resilient in the face of turmoil in other markets are the proximate cause of that turmoil. Late-cycle fiscal stimulus in the U.S. raises the odds of an inflation overshoot and makes the Fed lean more hawkish than they otherwise might. That’s USD+ and, by extension, EM-. On top of that, the side effects of the Trump administration’s fiscal policies contributed to the Q1 dollar funding shortage. The first quarter of 2018 was defined by a technical dollar funding squeeze and a liquidity drain catalyzed by three key drivers (this is Goldman’s list, but there’s a general consensus on this across markets):

1. The change to the tax treatment of foreign earnings from US companies;
2. Changes to the Base Erosion and Anti-Abuse tax (i.e., BEAT);
3. The surge in T-bill issuance.

If the effects of that stimulus end up wearing off (i.e., if it proves to be a sugar high, as many economists contend), then U.S. equities will catch down to the rest of the world’s reality. [Note: that needn’t be the end of the world, so save me the “you’re a permabear” accusations – even if U.S. stocks tumbled into a bear market, it would hardly make a dent in your gains if you bought at the lows in 2009]

On Monday morning, the dominos started to fall in earnest for emerging markets, as the South African rand crashed and other developing economy currencies fell in sympathy with the lira. The MSCI emerging markets currency index, which had its worst day since May 2017 on Friday, fell sharply again on Monday to its lowest level in more than a year.

(Emerging market FX index falls for a fourth session / Bloomberg)

JPMorgan’s emerging market currency gauge is in the middle of a truly harrowing decline, having fallen some 15% from its 2018 highs.

(JPMorgan emerging market FX index careens lower in August, building on losses / Bloomberg)

10Y yields in Turkey have surged to near 23%. That’s more than double where they were this time last year at the peak of the carry euphoria.

(Turkish government bond yields soar as the crisis deepens / Bloomberg)

In yet another testament to the notion that this trade has, like the Norwegian Blue,  “expired and gone to meet its maker”, 1-month implied volatility on the lira has gone parabolic.

(1M ATM USDTRY volatility explodes; low on March 9 was 8.78 / Bloomberg)

Given all of the above, now is probably a great time to review the full newsletter penned by the above-mentioned Tim Lee in August of 2013. You can find it below.

Do note the last line:

The unraveling of the currency carry trade, which I have discussed again in this ‘monthly’, is a central part of this expectation and I believe the evidence says that it has already begun, which makes the one year horizon perhaps — finally – realistic.

That may not have been accurate in 2013, but it sure seems like it is now. “Finally.”

By Tim Lee, ca. August, 2013