Who comes up with these so-called brilliant arbitrage ideas? In this case, what is called the “Carry Trade.” We’ve seen similar happen before, and they last only a few days. Here is a simplified version of how it works. In the end, there is an advantage to what we do at Adams Financial Concepts. But before we get to that, here is an example.
Suppose earlier in the century you borrowed $1 million from Japanese banks. The interest rate is negative, which means they pay you a little interest to borrow. You take the $1 million and invest it in US Treasury bonds paying 4%. Since they are treasury bonds, you can margin them 90%. So, you use the $1 million to buy $10 million of treasury bonds. The rate you pay for margin is 1.5%, so the net is 2.5% on $10 million, or $250,000 on an initial investment of $1 million. Nice return as long as it lasts. All of that before COVID and post-COVID when the Fed began to raise interest rates, and the margin interest rate was higher than the US Treasury bond rate. So now instead of US Treasuries, you switch to buying US and Japanese stocks with the money you borrowed from Japan at no interest.
Once again, the return is very good. It is very good until the Bank of Japan decides to raise interest rates because the Japanese economy is doing well. When the BOJ does raise rates, the Yen begins to increase in value against the American dollar and other currencies. So, in dollar terms, you must pay back not $1 million but maybe $1.1 million in US Dollars. At the same time, economic data in the United States show the US economy may be slowing, and the Fed may begin to lower interest rates. The value of the US Dollar begins to drop against other world currencies. So now to pay off the original $1 million, you must pay off $1.25 million in US dollars. Because of that, the Japanese banks who have loaned the $1 million and the American banks and brokerages who have advanced the margin all want you to pay down your debts immediately, like the same day.
So, you must sell American and Japanese stocks to “unwind” the positions.
But it is not $1 million. No one knows how much the carry trade is, but it is very possible it is no less than $500 Billion and may be more than $1 Trillion. On Monday, August 5, the Japanese stock market plunged over 12%. That was the biggest drop since 1987. It is the equivalent of the DOW dropping over 5,000 points.
But it is not just the carry trade. There are two other contributors: computer algorithms and actively managed mutual funds. The total of all world stock markets is about $27 Trillion. Of that, half is held in passive mutual funds. They adjust, but the trades are limited in number. Of the remaining stocks, it is split between actively managed funds, institutional funds, computer algorithm funds, and a few others. We cannot find what percentage of stocks are held in computer algorithm-driven funds, but it is probably less than 20%. But the number of trades they do is 85% to 90% of all trades done in the markets.
The computer algorithms were based on some initial code, but most of what the computers do is based on computer learning about the stock market and historical data. Computers make the trades with no input from human beings. When the computers in early August detected that there was a rush of selling, those machines piled on. They began to sell as well. So now you have the carry trades selling to unwind and the computers selling because they do not want to be left behind.
The additional factor is that money over the last several decades has been flowing out of actively managed funds into passive funds. I have heard that some companies that manage mutual funds have instituted a monthly profit system. If the manager makes a profit during the month, money is added to what they manage. If they are unprofitable in any month, money is taken away from them. So as the carry trades are unwinding, and the computers are selling, there are very probably a few active fund managers who are dumping stocks too.
All of that in a matter of a few days.
We have seen similar times before. In the 1990s, there were a couple of Nobel Prize winners and notable traders who put together an arbitrage fund called Long Term Capital. For years the fund earned over 15% annually, and it had grown huge. But in one day, the fund collapsed, wiping out all cumulative profits and most, if not all, the original investments. In one day! Because of its size, Federal Reserve Chairman Alan Greenspan brought together all the banks to force them to continue to fund Long Term Capital to unwind their arbitrage. I always wondered if the Nobel Prize winners had to melt down those gold Nobel Prizes to reimburse investors.
None of this has anything to do with the value of the stocks. But the price of the stocks will fall off. At Adams Financial Concepts, we will use the situation to shift some of the holdings in the portfolios. It will not be a lot of shifting but will add incrementally to the returns we expect to achieve over the longer term. For new accounts, it means getting in at very good prices.
