The Largest Financial Trade In History And Its Risk
This is a post by Daniel Morcillo, a special contributor, who reflects on some of the issues we have been discussing here since 2011 (the “sudden stop”, the end of the commodity supercycle, the deflationary nature of QE and the unpredictable impact on the world economy of the normalization of monetary policy).
While the majority of media is now focused on the Hellenic, Hawks and Trump news, attention is lost upon a matter of greater concern to the world. Something the IMF and BIS analysts have been warning or a couple of years, which stands as the greatest trade seen in financial history. A trade that was originally thought to have been 1/3 of its actual size and which has been fuelled upon by Central Bank policy. I refer to the 9trn$ carry trade which has flowed into Emerging Markets and appears to be unwinding.
This call is not for a meltdown, but rather a global slowdown that could expose similarities with 2001 and deteriorate to 2008 levels in the worst case scenario.
This scenario is mostly based on a probable strong US$ throughout 2015-onward.
- Central Bank stimulation strategy of easing monetary and fiscal policy (i.e. lower interest rates and more $ liquidity) creates and leads to US outflow of carry trades from $ to EM (1).
- IMF in 2013-2014 warns of this carry trade and estimate it at 9trn$ (2015).
- Devaluing currencies (“currency wars”) of the majority of world economies , the Developed Markets need/chase for yield (2), the Emerging Markets need (?) for credit , Central Banks policies (+others…) lead to a deflationary environment.
- The misallocation of capital in an unwinding carry trade will make emerging markets more illiquid, spark volatility and moreover reflate the $.
- The very possible scenario of a bull $ in an ending commodity super-cycle (see below) could be very harmful for global growth. Starting at EM and lagging at DM (US then EU).
- Without knowing how these unintended consequences will exactly play out and when, the existing entrenched involvement of CB policy (e.g. FED hiking) could only attempt to cushion this probable scenario.
- The peak for the global “expansion” cycle has been undoubtedly positioned by China, who has seen large sums of this $ denominated capital inflow start to roll out (3,4) . I remember pondering back in 2013 at the exuberant irrationality of the Chinese government building empty megacities in the middle of nowhere. Today 1st August 2015, Chinese PMI signals 50.00 (even the PMI number looks manipulated), the PBC along with the Shenzhen and Shangai Composite and their trajectory speak for themselves even though US Hedge Fund consensus still stands bullish. Back to the central scenario, it would be of no surprise to see the RMB unpeg from the $ in CHF/EUR style or GBP/DEM (c.1992) flair.
- In this overall scenario, the situation of devaluing currencies vs a strong $ will inevitably lead to defaults, as the economic fundamentals of EM are stretched along with their voluminous $ denominated debt burdens.
“Significant emerging currency depreciation should cause investors to hesitate. Depreciation is a secondary form of “default”.” William H. Gross, 30th July 2015 (5)
- For me, the focus now is to see who will be the highest beta debris (once again, based on fundamentals) of this carry trade unwind as well as too see if, when and how it plays out. With a focus on fundamental analysis it is also crucial to analyze capital allocation of this carry trade and its embedded liquidity.
As much as I like to quantify things as much as possible and prove through probability and historical back-testing, this is an unprecedented event in the history of financial markets. This is not only because of the magnitude of the stimulus but also due to the fundamental situation of each economy, market and the varied nature of concerning factors (such as CB policy) concerning each economy individually and as a conglomerate (EM & DM). Depending on how you look at it; this is both a “This time it’s different” as well as the opposite.
This is more of an initially theoretical evaluation by connecting the dots of our global macro current situation which will be proven to be occurring through upcoming feed on world economic data. Regardless, current economic data does lead me to believe that this scenario which I have summarized above is increasingly likely, if not occurring now.
As an objective student of financial markets, I have to enforce that this is not a “doomsday” style global meltdown warning, but rather something I believe has to be on the eyes of market practitioners as it may fuel large sums of wealth destruction, slowing down global economic growth and lastly, at the same time aligning with the 3 standard-deviation historical average duration of the US economic expansion cycle of 83.64 months (or 7 years), before (statistically) we enter another recessionary cycle, led by the end of the commodity supper-cycle.
Further sources on the matter (cited above):
- https://www.janus.com/bill-gross-investment outlook?utm_campaign=Bill%20Gross%20Feb%20IO
By Daniel Morcillo