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Capitalist Exploits is a team of globe-trotting professionals dedicated to seeking out and investing into unique, undiscovered, and profitable opportunities worldwide. This could be an asymmetric trading opportunity in the global currency markets, seeding a tech startup in Israel, or... More
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  • Is This How It All Begins To Unravel?

    My daughter found a sick baby bird in our garage a few weeks ago. We took it in and began nursing it back to life. My daughter, a gentle little soul who believes that our home should be turned into an animal shelter for every imaginable creature whether it needs help or not, was interested in the species of bird we were looking after.

    This led us meandering down the ornithology path. After we'd identified our patient as a house sparrow, we continued looking at other birds. What we found was a particular species of bird which I immediately recognized as a bird which should be the mascot for sovereign debt.

    Fulmar chicks, like many small birds, are very cute looking. They look completely harmless. You can imagine cuddling one, taking it home to your partner and being rewarded with all manner of affection for being so thoughtful, "Oh dear, she's beautiful. What a lovely gift."

    The fulmar, however, has a little secret. This cute looking chick sprays puke all over anything which comes too close. This is a defense mechanism designed to ward off enemies. When you come too close to it, this seemingly innocent little ball of fluff will projectile vomit a type of rotten fish smelling oil all over you. Apparently it's incredibly difficult to get the vile smell off your skin even after using a wire brush in the shower. What a little bastard of a bird!

    bird puke
    If you so happened to be a predatory bird you're really screwed. The fulmar's "gut oil puke" acts like a form of unbelievably strong super glue, gluing your feathers together and making flight impossible. Should you decide to head into the water to rid yourself of this death vomit, the sticky vomit apparently causes you to lose your buoyancy and you drown!

    Murderous puke! And yet the bird looks harmless...

    Similarly, investors lulled into a false sense of security caused by linear assumptions, have loaded up on sovereign debt, believing mistakenly that they've got themselves a safe asset. It is the equivalent of a harmless sparrow. Something that can't possibly harm you. Boy, will they find a surprise when they open the shopping bag and realise what they've actually taken home. A vile stinking destructive package of crap, disguised as a safe investment. Risk free, they're calling it.

    Not long ago I showed how debt has risen since the 2008 crisis. In fact, today we have this unique situation where in Europe we're staring at 700-year lows in interest rates.

    Surely, with interest rates so low we'd expect to find a field of daffodils on the risk side. Declining yields on bonds would normally be attributed to lower risk of default. Stands to reason, but reason cannot be found today in the sovereign debt markets. Instead, we find that risk is off the charts.


    The yield on the 10-year German bond stands at mere 0.27% today

    When I stare through my murky windscreen the road ahead looks uncannily like the end of the great debt cycle. This is not the normal 7-year business cycle we're dealing with here and it makes timing all the more difficult. As tough as it is in calling the end of a long term debt cycle, why would anyone without the benefit of mind altering drugs take the tail risk of long duration sovereign debt for such paltry returns?

    Fed set to raise rates in June

    This is largely what the clowns at the Fed have been telegraphing to the world. Investing is not about "knowing" what will happen. Nobody knows what will happen. It is about probability, and furthermore about managing risk relative to probability.

    I'm going to go out on a limb here and say that if the Fed does indeed raise rates in June we're going to begin to see periphery sovereigns default. The probability isn't what matters so much as the price we have to pay in order to position ourselves to take advantage of that probability.

    Pray tell, what happens to European debt relative to US debt?

    My guess is that investors in European sovereign debt will puke as they realise that they've brought home the equivalent of a fulmar, instead of a soft cuddly barn swallow which couldn't do them any damage.

    Bonds cannot defy gravity forever. While interest rates are low all over the developed world, a significant divergence in relative yield may well be the proverbial straw which breaks the camels back.

    Two years ago I wrote about how a market needs only change at the margin. At the time I was discussing shorting the yen which we'd been short since 77 to the dollar (NYSEARCA:YCS). At the time it was just punching through 94 and Abe was just about to bring his padawan Kuroda onboard. It takes more than one meathead to do a decent job.

    In that post I mentioned how the more levered a market, the less resistance there is towards a change in direction.This is why it's possible for major changes to take place at the margin. When everybody thinks one way, who else is left to come to the party? The sovereign bond markets today sport these characteristics, and I worry that the results may turn out poorly. Perhaps really poorly especially for those holding European and emerging market sovereign debt.

    The impact on the carry trade

    Should the Fed raise rates in June, the impact on the carry trade will only be exacerbated.

    We've spoken at length about the carry trade, both in our detailed USD Bull Market report as well as my explanation of the anatomy of a carry trade bubble. It's important to understand how interconnected world markets are. Nothing happens in isolation.

    Consider investors, hedge fund managers, pension funds, and other financial flotsam and jetsam will now have added incentive to pay back borrowed dollars after their forays into emerging market debt and high yield instruments. Not only has the yield differential moved against them as dollar returns on a yield basis outperform. Equally importantly, this itself will simply fuel demand for the already strengthening greenback.

    A rate rise by the Fed will act as a margin call on carry trade assets as the yield differential widens in favour, this time of the dollar. This is why I fully expect some hair raising events in the 3rd and 4th quarters of 2015 as levered players who are currently coughing up blood actually die. It promises to be a good show.

    I should point out that a strengthening dollar (NYSEARCA:UUP) is deflationary on a global scale. I struggle to see how this is anything but bearish for commodities and commodity currencies.

    As terribly managed as the dollar is, we believe that global capital flows increasingly favour the USD. This will likely have the perverse effect of sending the wrong signals to US policy makers who understand global capital flows in the same way my young daughter understands quantum physics - not so much.

    This dollar rally and periphery debt default we're expecting will set the stage for the Fed to eventually attempt to reverse the strong dollar, bringing about a rise in US bond (NYSEARCA:TLT) yields and a loss of faith in the mighty dollar. We have more of the show to enjoy though before we get there.

    - Chris

    "We are experiencing very demanding times." - Jean-Claude Trichet

    Tags: UUP, YCS, TLT, Macro
    Mar 19 9:13 PM | Link | Comment!
  • Is US Dollar Carry Trade A Menopause In The Currency Markets?

    I had taken my then life savings earned from a job pushing shopping trolleys at the supermarket, and sent them overseas with a friend.

    I was 16 years of age and my life aspiration was to travel the world. I'd figured out that to do so I'd be needing (strong) foreign currency. My friend banked my money in Australian dollars and this was to be my very first major currency trade. I was long AUD/ZAR - a great trade for me over the following few years.

    I would look up the foreign exchange rates in the back of the newspaper my Dad brought home each night and I'd quickly calculate my P&L.

    This was my first experience with currency volatility and the ride was more uncomfortable than the notorious Cresta run.

    (click to enlarge)Costa Run

    I'd remember feeling elated when my holdings had increased showing me a profit, and terribly depressed when the inevitable opposite happened. My moods could probably have been easily predicted by that one currency pair.

    Many years later I'm the proud husband of a beautiful wife and this is where I've realised that understanding currency markets is the key to understanding women. I knew currency markets before I knew women so I think I had a "heads up". No excuses, heh!

    The ancient Greeks first attempted to explain mood swings over 3000 years ago but only in the last century did psychologists begin to figure out that we humans go through cycles from birth. These depend on the level of hormones pumping through our bodies at any given point in our lives. Husbands all over the world have to deal with this once a month. At least we know what's coming and we can prepare by retreating to our "man space" to retain sanity.

    Just the other day a male friend of mine was telling me about why he's spending so much time on the golf course lately. It turns out there is a correlation between time spent on the golf course and his wife hitting menopause. One minute everything is fine and the next his wife is a slobbering, weeping wreck with the psychological stability of half set jelly.

    I was curious so I looked it up and lo and behold, between the ages of 45 and 50 women go through this. Thank God I'm male but imagine that. It's predictable to within a 5 year window!

    Which does beg the question: where can we find such predictability in the markets?

    When looking at short-term cycles we have the business cycle which lasts roughly 5 to 8 years. Then we have longer term cycles such as the long-term debt cycle, secular cycles and so forth. The important thing to understand is not that these cycles exist, as any half decent macro investor understands this, but to understand what drives these cycles, what the catalysts may be causing them to rise and fall and then to further figure out where we may be in any given time-frame in any given market.

    In short, it's probably worth knowing when your wife may be hitting menopause so you can prepare accordingly. So too it's valuable to understand what cycles we're in when looking at global financial markets. Today as I write this we have MASSIVE warning signs in the carry trade. Something I detailed last week here and which we delve into with great detail in our US Dollar Bull Market report.

    Last week I answered (or at least I hope I did) a reader's question around how the massive US dollar carry trade has reached over $9 trillion. My answer hopefully showcased that we're dealing with a cycle here.

    This brings me to another question brought to us by a reader:

    Dear Chris and Brad,

    First of all I would like to express all my gratitude and admiration for you and your newsletter. I am working in a large Real Estate buyout firm in London, but your pieces made me re-evaluate my career path and look for a more entrepreneurial path within the investing space; I thank you for that.

    I am contacting you as your articles on China and the Yuan has captured my interest and I have to agree with all the points you make. My only concern, is that a long USD/CNH trade entails a negative carry of ~3% p.a., which makes the timing of the trade very important (given the 3trn+ USD reserves, could the PBoC delay even further the breaking of the peg while continuing with monetary easing?).

    I was wondering what are your thoughts on a long position in USD/TWD instead; it has a very low cost of carry and benefits from the majority of the dynamics seen for the USD/CNH. What are the drawbacks/offsetting factors to the long USD/TWD trade that I am not considering?

    I put this to Brad who responded.

    You are correct with the USD/CNH being a negative carry trade. However, this isn't a concern for us as this negative carry is built into option prices already. Furthermore, we see this negative carry narrowing over the coming months as the US begins to lift rates and China continues to cut.

    Lastly, in terms of timing - if time is cheap then timing the market is not important. Call options on the USD/CNH are extremely cheap. So given that we think that it is almost a "certainty" that the renminbi will devalue against the US dollar over the next couple of years we think that it will prove very costly to try and time the big move in the renminbi. So we will buy long term calls on the USD/CNH and continue to buy ourselves more time until the move gets underway.

    As far as the TWD goes - we don't really have any definite view on this currency (in any event we think that if we get the USD/CNH right then the payoff will more than suffice). Our other big "call" is for a material depreciation in the Singapore dollar (upside in the USD/SGD). This is already playing out with our option positions up some 500% in the last 12 months.

    Thanks for reading and have a nice weekend. Perhaps playing golf?

    - Chris

    "In fiction: we find the predictable boring. In real life: we find the unpredictable terrifying." - Mokokoma Mokhonoana

    Tags: UUP, Currencies
    Mar 15 11:18 AM | Link | Comment!
  • The Anatomy Of A Carry Trade Bubble

    Last week I discussed some very important things, not the least of which was how to get rock hard abs. Equally as important is how asymmetry builds in nature and in financial markets.


    Today I wanted to continue the discussion. A question posed by a reader prompted me to think about how to explain asymmetry in simple terms. Financial professionals, especially academics, have a tendency to make the simple sound as complicated as the internal workings of a viral disease. It needn't be that difficult!

    Here's the comment and question posed by a reader:

    "You guys completely nailed the lows in volatility last year and were positioned in the long dollar trade. I subscribe to a lot of publications and NOBODY I've read saw this, and then the repeated short renminbi call, I'm so grateful. Oh, meant to also deliver kudos since ages back when I first started reading you gents some two years ago re: your call on short yen at 77! I just wish I'd done something about it, but...hindsight right. I could have paid off my mortgage on that one.

    I do have a question though. In your Dollar Bull Report you discuss the carry trade. How is it that the carry trade reached $9 trillion? Maybe not how actually, but just why really. What made it happen? Thanks for all you do. Amazing information, and all free!

    - JD"

    Why, thank you. You make me blush!

    How the carry trade has reached such heights is an important topic since it goes to the heart of understanding how asymmetry builds. What is equally important to know is what to do with opportunities when they present themselves.

    Let's block and tackle the first one. But before that I will mention that we are putting together a very special service for subscribers that will cover multiple asset classes and provide unique opportunities we and our network are investing in. We want to make this accessible to as many as possible. This will be institutional-grade and I'm very excited about it.

    Back to the question. Let me answer it with an example:

    Buying a House

    Imagine, if you will, aunt Claire. Aunt Claire is a real sweetie, a teetotaler, who lives in a gated community, puts her teeth in a cup beside her bed every night, and stands to attention when singing the national anthem.

    Aunt Claire just bought a house. When she did so she took out a mortgage and as such is borrowing (shorting) dollars (or euros, francs, or any other currency). Aunt Claire is "long" the asset - the house.

    Nobody including aunt Claire would buy a house if they believed it would go down in value relative to the currency being used to buy it with. The same is true in any carry trade anywhere in the world.

    Let us assume that aunt Claire purchased this house as an investment in year one and it cost her $125,000. Let's further assume that LVR is 80/20 and the cost of capital is 5% or $5,000 per year.

    Year two rolls around and home prices have risen by 10%. Now, aunt Claire isn't too bad at math. In her day she actually learned to add in her head without the use of a smart phone, and as such she quickly realises that investing in housing is the way she can finally get rich. She's only got a few decades left before the arthritis really kicks in and nurses start taking away her nightly port shots. She's keen to make the most of a good thing.

    Aunt Claire focuses on the fact that in one year she added over $26,000 to her balance sheet. Since she only put down 20% of the purchase price her IRR is sitting at a whopping 58% and her cash-on-cash return is over 30% in just one year! She rushes out to get a new set of teeth and settles down to figuring out how much money she'll be making next year. Smartly she begins to imagine what it would have looked like with more leverage. Aunt Claire is no different to hedge funds managing billions of dollars.

    Aunt Claire enjoys a boom as house prices keep rising year after year. As prices keep rising so too aunt Claire decides to buy a few more houses, and so the leverage grows. More participants enter the market, all of them borrowing (short) dollars. Initially this makes sense since there is positive carry.

    (click to enlarge)New Homes Sales Prices

    Let us now deal with the very simple way of determining whether the boom is produced as a result of productivity growth or if it indeed exceeds productivity growth. Where a divergence between the two opens up is where asymmetry lies.

    Let's look at this from a different perspective. Consider that asset prices are typically a multiple of revenue. In the case of house prices they are therefore priced at a multiple of cashflows. Cashflows come in terms of rent received or household incomes.

    Let's go back to Year 1 with aunt Claire.

    • House price $125,000
    • Cost of capital $5,000 (5%)
    • Income/rent $13,000 (10% gross yield)
    • P&L $8,000

    Looks OK so far.

    Now, let's hop into our red hot time machine and race to year 10.

    • House price $324,218 (10% compounded annual growth)
    • Cost of capital $5,000 (still at 5%)
    • Income/rent has risen to $15,000, providing her now with a 4.6% gross yield

    What just happened is that asset growth has exceeded productivity growth. Yields have collapsed from 10% to 4.6%. Productivity growth can be seen in incomes/rent earned and it's clearly not kept pace with asset price growth. I'm being simplistic here and certainly there are any number of factors that could justify why this situation may make sense. Supply shortages, for example, can cause periodic distortions, and certainly in today's world the largest of these distortions has been declining interest rates causing the cost of capital to plummet.

    This is not dramatically different to what is taking place on a global scale when you hear about the carry trade. In the above example I can already hear many of you screaming at me: "But Chris, interest rates have fallen over the last 10 years so productivity growth doesn't have to keep up with asset growth to the same extent." Ah yes, and therein lies the seeds of the greatest asymmetry of all - global debt. A topic too detailed to cover today, but one which we cover in depth in our Global Debt report.

    To Wrap it All Up...

    The carry trade is the borrowing (shorting) of one currency in order to invest (go long) in either another currency or assets denominated in another currency. The world's funding currencies are typically the Japanese yen (NYSEARCA:YCS), the US dollar (NYSEARCA:UUP) and the Swiss franc.

    The target currencies could theoretically be any currency providing a positive yield differential. The remnimbi has been a MASSIVE beneficiary of the USD/CNY (NYSEARCA:CYB) carry, as detailed in our USD Bull Market report and multiple times on this blog.

    Raoul Pal, co-founder of the absolutely brilliant Real Vision TV, estimates that the carry trade in China alone is $3 trillion.

    As a side note: If you've not signed up for Real Vision TV, I strongly suggest doing so. What Raoul and Grant Williams have put together is fantastic - it's basically CNBC for smart people. Go sign up already. It's the cost of a few good bottles of wine and won't leave you with the headache. And no, we have no financial relationship with them in case you're wondering.

    Back to the carry trade... What's wrong with it?

    Nothing! People everywhere are participating daily in some form of a carry trade. What is wrong is not the carry trade per se, but a situation where productivity growth cannot keep up with asset price growth. When that happens defaults begin to hit as aunt Claire realises that she can't service her mortgages anymore, after she's levered herself up with 10 houses and interest payments are getting tight. Then she has to pay back the money she borrowed.

    This means she has to buy back dollars and in order to do so she'll be selling houses. The problem is buyers aren't interested in the houses offered at those prices and a very small move in the asset prices sets off a spiraling of selling houses to buy back dollars - an unwind of this particular carry trade.

    Asymmetry builds when market perceptions become divorced from the underlying. This is often reflected in deteriorating fundamentals on the back of rising asset prices. At the same time volatility is often found to be low or even decreasing as market participants, expecting a linear outcome, fail to see that risk is increasing and not decreasing.

    Volatility is a great measure for what the market determines to be risky. Think of volatility like insurance premiums. High volatility equals greater risk and low volatility the opposite. Keep your eye on volatility as one means of determining where asymmetry may be lurking because that, my friends, is where to go hunting for unicorns.

    - Chris

    "Bubbles arise if the price far exceeds the asset's fundamental value, to the point that no plausible future income scenario can justify the price." - Justin Fox

    Tags: CYB, YCS, UUP, economy
    Mar 10 11:06 AM | Link | 2 Comments
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