JPMorgan’s Marko Kolanovic has a message for markets: “There are many carry trades, and they can’t all be bailed out.”
That was the title of the bank’s latest asset allocation update, which found Kolanovic and co. retaining a defensive tilt in their model portfolio. They increased their Underweight in equities and raised their cash allocation.
To briefly recapitulate, Kolanovic turned cautious towards the end of last summer, and has retained that bent since. Last week, two days prior to the SVB collapse, he warned that “aggressive hiking cycles such as the one undertaken by central banks in Europe and the Americas historically didn’t end in a soft landing.”
Fast forward a week, and Marko described the measures announced by Jerome Powell and Janet Yellen on Sunday evening as “funding support for a specific carry trade.”
“Buying longer-term higher yielding bonds and funding with short-term funds doesn’t work with a steep yield curve inversion and downward pressure on the price of the long-term yielding asset,” Kolanovic dryly noted, adding that although the Fed may be able to defuse the risk associated with “this specific development,” he cautioned that in his view, “there are many carry trades that will be under pressure and it will not be possible to backstop all of them.”
Of course, the entire world became one giant carry trade a long time ago. By early 2018, central banks had effectively forced all market participants to choose between harvesting carry or going out of business, “not much of a choice, really,” as Deutsche Bank’s Aleksandar Kocic put it at the time.
Although the short vol bubble blew up five years ago, there’s a very real sense in which the short vol / carry trade broadly construed persists to this very day and is just now starting to unwind as a result of aggressive policy tightening.
“Carry trades develop during a period of cheap financing such as the one we had over the previous decade and in particular during the post-COVID QE,” Kolanovic went on Monday, before echoing a warning that’s become a fixture of weekly missives penned by BofA’s Michael Hartnett. In short: If you’re looking for the next shoe to drop, there’s no shortage of candidates.
“Commercial real estate has been under fundamental pressure for a long time (work from home, online sales, etc.) but was a good investment at zero interest rates,” Kolanovic said, adding that,
Private equity and venture capital produce yield via risk premia advantage at suppressed mark-to-market volatility and unlimited low-cost funding. Auto loans, levered loans, credit cards all yield well while short-term funding is plentiful and consumers strong. The Bank of Japan’s unlimited bond-buying funds various higher yielding assets globally, and so on.
Late last week, Hartnett sounded a similar warning. “[There are] so many potential catalysts for systemic de-leveraging events,” he wrote, citing government debt, shadow banking, private equity, crypto, speculative tech and real estate.
Writing Monday, Kolanovic reminded investors that “when the economy is slowing down and financing costs are rising, all implicit or explicit carry trades are pressured to unwind, leading to an end of the cycle.”
In JPMorgan’s view, that’s where we are currently, and that’s why the bank “remain[s] negative on risky asset classes.”
Whenever the yield curve goes negative, the search begins for reasons why “its different this time”. Most recently, some bulls were calling the current yield curve inversion merely an artificial construct of Fed hikes, no longer a reliable economic signal.
The yield curve is a primary input into the economy, not merely an output signal. Banks employ one of the higher-visibility and highly-leveraged trades, but as Hartnett, Kolvanic, H, and others have noted, there are many other carry trades vulnerable to inversion.
Inverted yield curves break (financial) things, some expected and others surprising. I imagine we’ll see more things break. The question will be if the breakages can be patched (BoE-Gilts, Fed-regional banks) or cannot, and how willing the Fed is to risk the breakage by pressing on with its inflation fight.
That last might depend on the Fed’s awareness of the potential and size of breakage and view of its ability to patch.
For bank asset-liability duration mismatch, I am fairly confident “the Feds” (Federal Reserve, Treasury, FDIC, etc) were aware there was a growing risk for which it had the necessary tools; the Feds know this aspect of the economy well. Shadow banking feels at the other extreme; I am less confident that the Feds know what to expect and I doubt their toolkit reaches there (for legal reasons). CRE might be somewhere in between.
Good comment. My bone to pick with the Fed was leaving qe on too long, then compounding the mistake with qt and a far too aggressive pace of tightening by raising rates. I was taught years ago in my money and banking course that regulation is one form/tool of monetary policy. Policymakers and politicians seem to ignore this. But about every 10 years we get this lesson again. The market also underprices counterparty risk with even more frequency. We are once again learning the hard way.
Look on the bright side – with all the indexation, passive investing, and ETF trading, there are always some good names that get unfairly thrown out with the KRE bath water, creating opportunities for us.
I spent the whole day manually pulling numbers from schedule RC-B of FFEIS 031 forms, trying to figure out which regionals might be opportunities. Along the way I realized one reason why these events have surprised generalist investors. The key data is not available on the common market data platforms, at least not the one I use which is the one that most buysiders use, so it’s hard to build screens and alerts.
Of course the street analysts have juniors pulling the numbers manually and writing notes, but how much time do most generalist PMs have for the junior sellside analyst assigned to cover regional banks, who might be extra credulous anyway because s/he only has a few years’ experience which didn’t include GFC?