Tuesday, May 12, 2009

The Risks of the Intertemporal Carry Trade

. Tuesday, May 12, 2009

Back in February, I noted that Obama was engaged in a sort of intertemporal carry trade with the U.S. currency: he was gambling that the money he borrows in the present will be worth more than the money he has to pay back in the future. At the time, this made sense, since he could borrow at interest rates near zero (occasionally even at or below zero), and future inflation expectations were positive. Therefore, the present value of money actually was higher than the (expected) future value. Obama was arbitraging the system, and could have his cake and eat it too; he could spend today, pay back tomorrow, and earn a bit of profit on the side. He was able to do this because nobody wanted to lend to private corporations due to risk, and U.S. government bonds are perceived as being nearly "risk-less".

But there are signs that those days may be over. In March there was a failed bond auction in the U.K., indicating that bond traders were not interested in funding more deficits at rates the British government was willing to pay. Last week, something similar happened in the U.S.: the demand for T-bills was tepid, and investors demanded higher interest rates before buying. Why is this happening? For one, now that the dust has somewhat settled from the financial meltdown, investors are more willing to lend to (some) corporations. This creates competition for investment funds ex ante, which means that the government will have to pay a higher price to get the funds it needs to spend in deficit.

There is another aspect to this, however. Because of Obama's expansive deficits, which according to CBO estimates (see picture above) will still be well over $1tn in 2019, there is a rising fear that the U.S. will have to either default on its debt or inflate it away. In other words, there is a growing risk that the U.S. government debt will stop being considered "risk-free," and investors will demand a risk premium on T-bills. If that happens, then Obama will either have to scale back his spending programs (as Gordon Brown has done), raise taxes on a broader slice of the population than just the top 5%, or both.

Obama's carry trade bet looked like a win-win a few months ago. But that was contingent on demand for T-bills remaining high, keeping yields down, and allowing the government to arbitrage a profit (or very small loss). If that doesn't hold, then the whole thing will blow up in Obama's face, and the consequences for common Americans won't be pleasant either.

As many investors discovered last fall, the risks of carry trading are always the same: you don't want to be holding the potato when the music stops. The costs of unwinding are high.


The Risks of the Intertemporal Carry Trade
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