Mohamed A. El-Erian is the former CEO and co-CIO of PIMCO. He is chief economic advisor to Allianz, chair of President Obama’s Global Development Council, and author of the NYT/WSJ bestseller “When Markets Collide.” Follow him on twitter, @elerianm.
In a visit yesterday to a local amusement park, my daughter and I thought that we were being quite clever by opting for the ride with no wait – the “Grizzly” river rapids ride. Other rides were already posting a 30 minute plus wait; we just walked straight on to this one, and enjoyed it several times.
As markets participants would say, it was counter-cyclical arbitrage trading at its very best! At least that is what we thought. Well, it turned out that there was a good reason why the “consensus trade” was elsewhere.
Being rather early in the day, the southern Californian sun was yet to warm up the air. As such, there was quite a discomfort to getting soaked at that time on the river rapid ride. The crowd understandably opted for other (non-water) rides, keeping this one for later in the day when the temperature was forecasted to reach 80 degrees F (27 degrees C).
The high-consensus trade in financial markets today is to reach for yield, almost any type of yield. It explains why Spanish interest rates traded below those on U.S. government bonds recently. It is also partially behind the new low 10-year yields in countries like Colombia and Mexico. It helps to explain why Greece, having restructured its debt and imposed considerable losses on bond holders, can now seriously contemplate a new sovereign bond issuance at around a 7 percent yield. And it is driving significant flows of investor funds into “carry strategies,” including high yield corporate bonds.
This huge investor appetite for carry is currently supported by three major arguments.
First, a deeply-held view of low economic and policy volatility: The global economy is stuck in a muted growth and low inflation equilibrium, minimizing the potentially-disruptive impact of sharp economic fluctuations. Also, key central banks are also committed to a “financial repression” strategy that contains volatility by anchoring policy rates, now and through forward policy guidance.
Second, the lack of attractive high-returning alternatives: With the impressive 2013 rally in developed markets, a growing number of investors are worried about equity valuation there. With allocations to emerging market equities still being held back by very fresh recollections of significant volatility there, there is an inclination to re-allocate some flows that would have went into more risky strategies to income-generating carry strategies.
Third, the opportunity cost of foregoing yield, any yield, is significant: Since carry pays you regularly, any shortfall in an optimal positioning consistently “bleeds” the portfolio – the negative impact of which increases when cash yields virtually nothing and the upside to price appreciation is capped by existing valuations.
The historical problem with carry trades is that they are prone to becoming way too popular, especially when supported by inflows that are not just attracted to the strategy but, importantly, are also being pushed out of other strategies by the unattractiveness there. Accordingly, timing becomes very important. If investors overstay their welcome in carry trades, the multi-period income earned can be easily wiped out by the price depreciation that follows.
Unfortunately it is hard to establish with much conviction how close the carry trade is to a major turn. Some valuations, including what is happening in outer peripheral European bond markets suggest we are getting closer. But the global economic and policy underpinnings continue to provide comfort; as does the reality of avoiding extremely low yielding alternatives or, at the other end of the risk/return continuum, even greater valuation concern.
Today’s generalized carry trade will remain in favor until investor comfort about central bank policy effectiveness starts to evaporate and/or there are clear indications of a global economic breakout (one way or the other). At that point, having established the basis for “the turn,” we should expect quite a sharp change in investor sentiment and positioning.
Realizing this, central banks are also likely to try to delay interest rate volatility as long as possible, also risking to overstay their own welcome in their current policy stance. Ironically, this also serves to increase the risk of disrupted markets down the road.
All of which takes me back to our amusement park experience. By opting to act counter-cyclically too early, we did face discomfort in the short-run. Fortunately it wasn’t excessive. And as the sun warmed up the day, two things happened. Our discomfort receded quickly; and the wait for this wonderful ride quickly increased to 60 minutes plus!