Friday, September 25, 2009

Who is Buying all of our Government Debt and why? Understanding the Carry Trade.

A carry trade may be a new concept to many of you so let me explain what a carry trade is for investors. In its simplest form a carry trade is a leveraged transaction. If an investor can borrow money at a low enough cost they might be able to invest the money in something that will pay a higher return than the interest expense to borrow the money thus earning the difference called the spread.

If an investor could borrow money in Japan at lets say one quarter of one percent (25 basis points) and can buy US Governments with a yield of 3.4% then he makes the difference between the cost of money and the actual cash flow. In our example the spread is the difference between borrowing at 25 basis points and earning at 3.4% or 3.15%. This spread is 12.6 times greater than the cost of funds, the net of 3.15% divided by.0025 (the 25 basis points).

US Government bonds can be leveraged at pennies on the dollar. Let us assume that we stay within the acceptable leverage that the government thinks is reasonable for US Banks and that leverage ratio is 10 to 1. If we take our example and leverage it 9 more times then our potential return is the 3.4% interest on our initial buy and 3.15% times 10 times. The potential outcome is 3.15% time 10 plus the initial 3.41% on the first bond. The bottom line in this carry trade is the potential of just under 35% return.

Look at the chart below at the bottom you will see the light green line. This line represents the cost of money in Japan.

For over 10 years you could borrow money in Japan for less then three quarters of one percent. The rest of the charts show all the places you could take this money and leverage it as we illustrated above in a carry trade transaction.

There is now a country that is offering interest rates lower than Japan. Can you guess who that country is? The good old US of A. The cost of short-term money in the United States is almost half of what the cost of money is in Japan. Japan has kept interest rates low for over 10 years trying to stimulate its economy but to no avail. The US Central Bank has provided over $1.5 trillion dollars of liquidity in the credit markets to avoid a serious depression in the United States. The US is now in the carry trade business in a huge way. If Japan has had to keep short interest rates low for 10-years to try and protect its level of economic growth then why are so many people talking about the Fed and its exit strategy and begin to raise interest rates. As I have said before I believe that this recover will be low and slow the Fed will be reluctant to increase interest rates with unemployment at almost 10%.

People keep asking why are investors are buying up all of out new issue Government debt? The real answer is that US Government debt has one of the lowest costs and the greatest opportunity for leverage—the carry trade than almost any other fixed income security. If the Fed keeps interest rates low and I think they will, the American carry trade will be around perhaps as long as the one in Japan.


Dan Perkins

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