Carry trade - Räntearbitrage at IntCom

I found some data that Stephen Roach of Yale, formerly a chief economist at Morgan Stanley, had put together or found that the
IMF had stated that roughly $4 trillion dollars had flowed into emerging economies. And so India would be one of those.

And so it's really instructive to understand the mechanism of what's actually happening here. This is a story of a virtuous circle and then a vicious cycle. And the virtuous circle works like this:
The Fed prints up a whole bunch of money, several trillions of dollars, buying mortgage-backed securities, buying Treasurys.
That ends up in the hands of the primary dealers, the big banks, JP Morgan, Citi, Chase, all those guys.

And then they do something with it. Typically, they’ve got to go find something to do with it. And they've been loaning it hand-over-fist to speculators – we might call them hedge funds, private equity firms, other private investor groups – that will then take that money and then leverage it up.

So let's imagine – just to make the whole numbers here – you're a big fund. You've taken a billion dollars. You want to leverage that up 10:1. Now you have $10 billion. And so you wander over towards India, because you borrowed your money at something really favorable, maybe 2%. And you're noticing that India has these tasty 7%. 7.5%, 8% ten-year bonds.
So you want to go buy those with U.S. dollars.

So you go into the open market; you buy rupees with your dollars.
That tends to depress the dollar slightly, and it tends to elevate the rupee then a little bit more slightly.
So now you have all these rupees. You wander over into the Indian bond market with your rupees. You buy $10 billion dollars, or ten billion dollar equivalent in rupees, of ten-year bonds, just in their market.

This has a couple of effects. The first is, it washes $10 billion new Rupees into their markets, which is a whole lot of new liquidity that just sort of showed up out of nowhere. And secondarily, it increases the price for those bonds. That means it drives the yield down. Oh, the Indian government loves this. Their borrowing costs are going down! Their bonds seem to be in favor! So it's a welcome move.

And then there's this knock-on effect, because the $10 billion dollars’ worth of rupees is now cycling through the Indian market. Well, guess what? Some of that ends up in the stock market. So your stock market goes up. So everything's awesome in this story so far. The rupee is nice and stable. It's strengthening slightly. The Indian stock market's going up. Their bond yields are falling. All of that's awesome.

And the un-awesome part of this story is that typically emboldens the local government to say, well look, we're doing everything well.And so what happens next is maybe they spend a little more than they should; the typical political largesse that happens when you think your markets can support it.

Well, then you get to the opposite side of that story, which started breaking about a month and a half ago but really accelerated in the past week, where we have to reverse that entire process.

So now you have that same hedge fund; you've got $10 billion equivalents of these bonds. You have to sell them. So you sell them. That tends to depress the price of the bonds. That means that the yield is going to go up. So all of a sudden their yields are spiking. Then you take these $10 billion dollar equivalents of rupees and you trundle over to the foreign market and you exchange them for dollars. That drives the rupee down.

And secondarily, now there is $10 billion dollar equivalents less of rupee equivalents in the market because they've been siphoned out. And so the stock market starts to fall as a consequence.

And that's exactly what we've been seeing in India right now. Falling rupee dramatically, falling stock market; rising bond yields on the sovereign debt. And now that we're on the vicious side of this circle, nobody's crowing about their financial prowess over there anymore. They're worried; they're scared; their reserves have been drained out of their central bank. It's a mess.

And if you are somebody who's living in India – and many people there live close to the edge financially – you've just discovered that your food and fuel has gone up by 24% in a two-month period. And that is a really, really extraordinary blow, not just the amount of it, but the pace of it.

So it's a really unwelcome situation.

A couple years back, Western investors — discouraged by low returns both in the United States and in the noncrisis nations of Europe
— began pouring large sums into emerging markets. Now they’ve reversed course.
As a result, India’s rupee and Brazil’s real are plunging, along with Indonesia’s rupiah, the South African rand, the Turkish lira, and more.
Paul Krugman, New York Times, August 22, 2013

Does this reversal of fortune pose a major threat to the world economy?
I don’t think so (he said with his fingers crossed behind his back).

Currency traders said expectations of looser US monetary policy raised the prospect of
a return of the so-called dollar “carry trade”, in which investors take advantage of low US interest rates to invest in higher-yielding currencies.
FT August 3, 2010

The dollar has fallen to multi-month lows against the world’s major currencies as investors bet that evidence of a faltering US recovery will lead to further monetary easing by the Federal Reserve.

When central banks start implementing exit strategies,
there is the potential to deliver a whole new range of currency upheaval,
particularly in relation to the crucial, but oft-ignored, issue of the dollar carry trade.
Gillian Tett in Davos January 28 2010

He added that in the past year numerous investors are thought to have used the ultra-cheap dollar funding on offer to pour money into emerging markets. Thus, when the US starts tightening, there could be huge “volatility”, with some unpredictable consequences.

With all due respect to her colleagues, she is the best source of financial news.
naked capitalism blog, August 13, 2007

"What’s causing all the trouble is a `carry trade’ unwind by real estate companies and people in Eastern Europe who borrowed in francs to buy houses.
They are in effect being bailed out at the cost of the Swiss taxpayer."
Ambrose Evans-Pritchard, 21 July 2010

Data from the Bank for International Settlements shows that external lending in Swiss francs reached $643bn in 2007 as borrowers from the Baltics to Poland, Hungary, and the Balkans, and even Austria tapped into Europe’s lowest interest rates, often pushed by their own banks. In Hungary it became difficult to obtain a loan in local forints.
The SNB /Swiss National Bank/ warned then that this carry trade was hazardous. "A little common sense would not go amiss," it said.

Forex lending represents around 91 per cent of the total in Latvia, 87 per cent in Estonia and 72 per cent in Lithuania
and over 50 per cent in Hungary, Romania and Bulgaria
a senior official at the European Bank for Reconstruction and Development FT 19/1 2010

At the height of the crisis this level of exposure raised fears that banks operating in the region would take big hits to their asset books as customers defaulted.

However, massive interventions by international financial institutions and an improvement in western European export markets have since helped to stabilise eastern European currencies, making such loans more affordable.

You have been warned about “the mother of all carry trades.”
Emerging economies “might overheat and experience financial turmoil,”
Bank of Japan Governor Masaaki Shirakawa said
Low rates and the dollar’s depreciation present “new, real and insurmountable risks to the recovery of the global economy,”
Liu Mingkang, China’s top banking regulator, said
Bloomberg, Nov. 16 2009

Lars Christensen, chefsekonom på Danske Bank, blev bespottad och utbuad när han på ett tidigt stadium varnade för en baltisk krasch.
Torbjörn Becker, chef på institutet för tillväxtekonomi vid Handelshögskolan i Stockholm, betonade på att det inte är staten utan hushåll och företag som skuldsatt sig grovt.
Skevheterna uppstod när letter under 15 procents inflation fick låna euro till 7 procents ränta.
"Hushåll fick betalt för att låna i euro, i reala termer", sa Torbjörn Becker och förordade att Lettland släpper sin valutakoppling till euron
DI 2009-07-02

Carry trade funding currencies - such as Yen, Swiss franc, US dollar - are appreciating on a trade-weighted basis.
High yield currencies facing selloffs as carry trades unwind on deleveraging
RGE Monitor 27 oktober 2008

BNP: Carry will end in 2008. Why? 1) Pressure for Asian currency appreciation will blow Bretton Woods II into pieces. 2) Banks' balance sheet de-leveraging due to frozen money markets. Non-US banks hold a $10trn USD-denominated funding position - the globe's biggest carry trade. Reduction of USD-denominated liabilities by non-US banks will create USD demand. EM FX volatility will surpass that of G10

Bernanke:
“the Fed must take into account the various effects of foreign capital flows on US yields and asset prices,
a task that can be quite challenging.”
FT 3/3 2007

Den japanska valutan steg till den starkaste nivån mot dollarn på ett år efter att den så kallade carryhandeln, där man lånar i lågräntevalutor som yen och placerar i högavkastade tillgångar, tappar sin attraktionskraft.
Yenen noteras på morgonen svensk tid till 112,4 mot dollarn.
Fallet på Tokyobörsen tilltog under sista handelstimmen och Nikkei 225 stängde ned 5,4 procent, vilket är det största raset sedan 12:e september 2001, enligt Bloomberg. Det bredare Topindexet rasade 5,6 procent.
DI 17/8 2007

The euro slipped to a six-week low against the U.S. dollar on Wednesday and
high-yielding currencies stayed weak as investors continued to unwind risky positions
on concerns that fallout from the U.S. subprime problems is spreading to other countries.
CNBC/Reuters August 14, 2007

The yen firmed broadly on Friday as continued turbulence in global financial markets caused investors to shun risk,
cutting their exposure to carry trades.
CNBC August 10

High-yielding currencies like the Australian and New Zealand dollars weakened sharply as steep declines in global equities further soured investors' risk appetite already hit by fears of a liquidity and financing squeeze.

Short term U.S. dollar deposit rates on Friday surged above 6% well above the Federal Reserve's 5.25% Fed funds target rate as banks scrambled for cash amid deepening concern about credit market losses, which pummeled equities and spurred a rush to unwind risky carry trades.

How much the world has changed, and not for the better,
due to the irresponsible behavior on the part of the Bank of Japan and Alan Greenspan's Federal Reserve
over the past 20 years or so.
Bill Fleckenstein 6/8 2007

A market correction is coming, this time for real
The yen carry trade has also facilitated the buoyant expansion of investments and leverage evident everywhere today.
William Rhodes, FT March 29 2007

This week we look at the yen carry trade, delve deeper into the mortgage lending world,
and see if we can find a possible connection between them and the economy in general through something called complexity theory.
As I have written for many months, I think the subprime mortgage problems
are going to be the catalyst for a recession.
We look at some ways that the contagion in this small part of the housing market could spread.
John Mauldin's Weekly E-Letter, 16/3 2007 - Full text

Ubiquity:
The Science of History or Why the World Is Simpler Than We Think by Mark Buchanan (Author)
"It was 11 a.m. on a fine summer morning in Sarajevo, 28 June 1914, when the driver of an automobile carrying two passengers made a..."
Read more here

Chinese purchases of yen
China reportedly wants to diversify large portions of its $1,000bn of foreign exchange reserves out of dollars. It is otherwise likely to sustain one of the largest capital losses in history
Fred Bergsten, Financial Times 13/3 2007
Very Important Article

Dollar-euro? It's the yen, stupid
The dollar hit a record low against the euro this week, but the bigger story for many currency watchers was the greenback's slip against the yen.
That's because a sharp rise in the yen could have nasty consequences for millions of investors around the world.
CNNMoney July 13 2007

For years, investors have been borrowing at Japan's super-low interest rates and selling yen to buy investments in higher-yielding currencies - a trading bet known on Wall Street as the "yen carry trade."

A big, sustained rebound in the yen could jeopardize those trades, Laidi said. "The yen is a funding currency. When it rallies, it makes the repayment of those yen loans more expensive, even though interest rates are low," he said.

The great concern is that if everyone tries to unwind the carry trade quickly that could slow a tide of money that's helped drive a record boom in private equity buyouts and push stocks higher worldwide.

To say the least, market sentiment is getting crushed globally.
Now, combine this with still huge Yen carry overhang, and a seriously deteriorating US economy,
and we will now see, and are seeing, the emergence of a world liquidity crisis.
Chris Laird, March 15, 2007

Unwinding the Yen, Unravels Global Stock Markets
The Nuts and Bolts of the “Yen Carry” Trade
Gary Dorsch, March 13th, 2007

Equities look overvalued,
but where is the turning point?
Any long period of market stability encourages speculation. Taken to excess, such risk-taking, particularly when fuelled by huge amounts of borrowing, can create significant instability.
Martin Wolf, Financial Times, March 7, 2007

Greenspan: says yen carry trade is going strong but there could be a turnaround at some point.
Money CNN March 7 2007

Carry trades weaken the Japanese currency, because investors sell the borrowed yen to convert them into other currencies.
The Economist print edition 8/2 2007

Carry trades make sense only if the investor assumes that the yen will remain weak. If it appreciated, this would increase the repayment cost of yen-borrowing and offset the interest differential.

In theory, carry trades should not yield a predictable profit because the difference in interest rates between two countries should equal the rate at which investors expect the low-interest-rate currency, here the yen, to rise against the high-interest-rate one.

End to ‘carry trade’?
The credit market is not the only source of liquidity for world markets that is under threat. John Authers, Investment Editor Financial Times August 2 2007

The “yen carry trade” – selling short the yen, at its low interest rates, and buying high-yielding currencies such as the New Zealand dollar – also looks sickly. This trade, popular with hedge funds, is vulnerable to a rise by the yen. And in the last month, the dollar has lost 4.3 per cent against the yen, while the kiwi has lost more than 7 per cent.

Some say the carry trade is not the speculative bubble it first appears. They rely on “Mrs Watanabe” – the archetypal Japanese retail investor. With tiny interest rates at home and a weakening yen, it makes sense for Mrs Watanabe to put her money overseas. She weakens the yen and boosts other markets as she does so. She even seems to be making more bets against the yen at present.

Carry on speculating
How traders have been triumphing over economic theory
The Economist print edition 22/2 2007

But why does the carry trade work? In theory, it shouldn't—or not for as long as it has. Foreign-exchange markets operate under a state of “covered interest parity”. In other words, the difference between two countries' interest rates is exactly reflected in the gap between the spot, or current, exchange rate and the forward rate. High-interest-rate currencies are at a discount in the forward market; low-rate currencies at a premium.

If that were not so, it would be possible for a Japanese investor to sell yen, buy dollars, invest those dollars at high American interest rates for 12 months and simultaneously sell the dollars forward for yen to lock in a profit in a year's time. The potential for arbitrage means such profits cannot be earned.

A recent academic study - The Returns to Currency Speculation - has shown that high-rate currencies have tended to appreciate and low-rate currencies to depreciate, the reverse of theory.

What does seem plain, however, is that the carry trade tends to break down when markets become more turbulent. In such conditions, those who borrowed yen to buy other assets (such as emerging-market shares) might face a double blow as the yen rose while asset prices fell. If the turbulence were sufficiently large, many years' worth of profits from the carry trade might be wiped out. A steamroller could yet restore the reputation of economic theory.

I keep reading how this is all okay with everybody because nobody understands derivatives!
The real, Sinclairian truth is that they understand it perfectly, as derivatives are very, very easy to understand; these are all just bets that were created, bought and sold for one silly equation-related reason or another, and the Federal Reserve created all the money to finance it.
The Mugambo Guru 7/2 2007

The biggest potential danger isn't from a slowdown in the U.S. or Chinese economies.
It's from the pyramid of leverage in the debt markets created by traders and speculators using cheap money from around the globe, and in particular from Japan.
The sell-off of Feb. 27 demonstrated how a panicked unwinding of that pyramid of debt could send financial markets into chaos.
Jim Jubank CNBC 6/3 2007

What's more important is what Bernanke didn't say: that this time, the biggest potential danger isn't from a slowdown in the U.S. or Chinese economies. It's from the pyramid of leverage in the debt markets created by traders and speculators using cheap money from around the globe, and in particular from Japan. The sell-off of Feb. 27 demonstrated how a panicked unwinding of that pyramid of debt could send financial markets into chaos.

While everything else, except for safe U.S. Treasurys, fell, the Japanese yen rallied by about 2%. The most likely explanation is that the traders and speculators who had borrowed in Japan at 0.5% interest rates to invest in everything from New Zealand bonds to U.S. stocks were selling those assets in local currencies and then buying yen to repay their loans.

Jim O'Neill, chief global economist at Goldman Sachs:
investment firms playing the "carry trade" had been caught on the wrong side
of huge leveraged bets against the Japanese yen.
Ambrose Evans-Pritchard, International Business Editor Daily Telegraph, 06/03/2007

"There has been an amazing amount of leverage on currency markets that has nothing to do with real economic activity. I think there are going to be dead bodies around when this is over," he said. "The yen carry trade has reached 5pc of Japan's GDP. This is enormous and highly risky, as we are now seeing."

Stephen King, chief economist for HSBC, said it would take two or three weeks to gauge the severity of this shake-out. "The world economy is fundamentally strong, but this reversal of one-way bets built up over years creates great uncertainty. The key worry is that this could reveal a weakness in the architecture of financial markets. We just don't know who is trying to liquidate positions," he said.

Bernard Connolly, chief strategist for Banque AIG, said conditions now are more threatening than they were in the six-week sell-off last spring.
"The carry trade was bound to end with a bang rather than a whimper but this doesn't look to me like forced liquidation yet. However, the yen is going up against all currencies this time and not just the dollar, and stocks are looking more panicky.
"This is going to go on for longer because there has unquestionably been a global financial bubble. Eventually, central banks will reflate but it will have to get worse first. "

Hiroshi Watanabe, Japan’s hawkish deputy finance minister for international affairs, has put a conservative estimate on the trade of between $80 and $160 billion. But nobody knows how much has been borrowed in yen to be sent abroad, which makes it difficult to estimate the effect as the trades unwind. (Economist)

Armageddon Sells: Permabears Now Becoming Cool
Albert Edwards forecasts a “bloody, deep recession” that produces a stock market collapse of at least 60 percent,
followed by years of inflation of 20 percent to 30 percent
New York Times 10 Aug 2010

In many smart-money circles, listening to bears has become fashionable, especially now that doubts remain about the sustainability of the euro zone, concerns grow that the United States may slip back into recession and that even the Chinese growth engine may seize up.

Could it really have arrived? Are global stocks about to tank in an all consuming way?
Indeed, is this the moment Albert Edwards has been waiting for since 1996?
Of course, Edwards is perhaps London’s best-known doom-monger when it comes to stocks.
FT Alphaville Monday, March 5th, 2007

Some strategists are more cataclysmic. Not invited to Jackson Hole was Albert Edwards, Société Générale’s famously bearish global strategist,
who warned this week the crisis would not be confined to emerging market economies with yawning current account deficits.
“I see this as the beginning of a process where the most wobbly domino falls
and topples the whole, precarious, rotten, risk-loving edifice that our policy makers have built,” he wrote in a note.
Financial Times, August 30, 2013

Only the Argentine Peso is weaker against the greenback this year
One of the more remarkable things about this selloff is how broad based it is.
The dollar is weaker in 2018 against all major currencies.
Widening the basket to the extended majors, only the Argentine Peso is weaker against the greenback this year.
Bloomberg 25 January 2018

Eisuke Sakakibara
the former Finance Ministry official said he expects the so-called yen carry trade to continue for some time. He said it's necessary that the trade unwinds slowly.
The yen headed for its biggest weekly gain against the dollar in 14 months after a slump in emerging-market stocks and bonds discouraged investors from making the trades.
Bloomberg 2/3 2007

Eisuke Sakakibara, vice finansminister i slutet på nittiotalet och numera professor på Keio-universitetet i Tokyo, bjöd på en frisk fläkt av japansk frispråkighet. Sakakibara, även känd som "Mr Yen", blev berömd internationellt för sina öppenhjärtliga uttalanden i ekonomiska frågor - vilka regelbundet orsakade fluktuationer i yen-kursen.
Exportrådet

Why so much money? Because we are in the bubble phase of a credit expansion. And one of the highlights of this period is that the Bank of Japan will lend money at less than 1%.
This tempts speculators to enter the 'carry trade,' in which yen are borrowed…carried over to dollars or other currencies…and invested in higher-yielding assets.
The Daily Reckoning March 1, 2007

Anyone with any sense could see that all this fresh and eager money was going to get a lot of people in trouble. And anyone who bothered to read the headlines could see the trouble coming in fast.

Wall Street was set to open sharply lower on Thursday as a strengthening yen stirred concern that investors were being forced to unwind carry trades
in a repeat of the risk aversion that sparked Tuesday's global market rout.
CNBC 3/1 2007

Two things worry people. The first is the “carry trade”, which involves investors borrowing a low-yielding asset (often the yen) and buying a higher-yielding one.
The second is the low cost of credit, and the rapid growth in credit derivatives, which allow investors to insure against default.
The Economist 1/2 2007

Past financial-market wobbles have been associated with periods when the carry trade was unwound. No one knows precisely how much capital is involved. But Tim Lee, of Pi Economics, reckons as much as $1 trillion may be staked on the yen carry trade. Were the yen ever to rise sharply (making the trade unprofitable), there could be hell to pay in the markets.

Were defaults to rise, the ability of the markets to absorb losses (and clear trades) might be severely tested.

Japan raised interest rates to 0.5%
In July last year, the bank raised the rate to 0.25% following six years of zero interest rates
Financial Times 21/2 2007

The carry trade is attractive as long as money borrowed in Yen finds sufficient returns elsewhere and/or the Yen itself continues to sink.
Michael Shedlock 15/2 2007

Marc Faber:
I suppose that the yen carry trade will unwind one day when global liquidity becomes tight.
Since all asset prices rose between 2002 and the present day, all asset prices will then suffer.
FT december 2006

Interest Rates, Carry Trades, and Exchange Rate Movements
Federal Reserve Bank of San Francisco, Economic Letter November 17, 2006

What is the carry trade?, Not profitable in theory, but profitable in practice
Carry trade profits and exchange rate swings, How big is the carry trade?
Conclusions, References

Bank of Japan estimating that there are up to Y15,000bn (GBP 67bn) (RE: * SEK 13,50 = SEK 904 miljarder) of outstanding yen carry trades worldwide. If volatility in both equity and currency markets is indeed set to turn up, the biggest potential upheaval will be in carry trading, there will be painful adjustments as the yen, the Swiss franc and other carry trading currencies appreciate sharply and liquidity is withdrawn from markets.
John Plender, FT, November 13 2006

If he is right and volatility in both equity and currency markets is indeed set to turn up, the biggest potential upheaval will be in carry trading, where people borrow in low interest currencies to invest in higher yielding assets. Carry trading is a punt on lower volatility. If the trend turns, there will be painful adjustments as the yen, the Swiss franc and other carry trading currencies appreciate sharply and liquidity is withdrawn from markets. With the Bank of Japan estimating that there are up to Y15,000bn (£67bn) of outstanding yen carry trades worldwide, there could be big damage if financial institutions are caught by the turning tide.

The Leverage in the System and the Weak US Dollar
By GaveKal Research, at John Mauldin, 26/6 2006

The truth of the matter is that the FT's headline is based on three premises, all of them wrong:
That imports and exports should balance over time.
That imports and exports have similar margins.
That one should compare the deficit with the GDP.

Recent events in the financial markets have had less to do with US$ weakness (hence the stupidity of the FT's headlines) as with strength in the Yen.

In the dim and distant days of the 1990s, market strategists believed in something called the Fed Model. This said the earnings yield on equities tracked the Treasury bond yield. When the graph shifted by a couple of standard deviations, it was time to buy or sell equities, as the case might be.
Tony Jackson, Financial Times 29/5 2006

Japan emerges from deflation. The Bank of Japan responds by ending "quantitative easing", its policy of flooding the banking system with economy-buoying liquidity.
Everyone is delighted that Japan's economy has improved sharply, that growth seems entrenched and that deflation looks beaten. But ...
Chris Giles, Financial Times Economics Editor, FT 10/3 2006

Stephen Roach, chief economist of Morgan Stanley and a long-standing pessimist about the world economy, wrote this week that "the biggest news in close to a decade is that the BoJ now appears to be on the cusp of abandoning its policy of über-accommodation".

It could halt the "carry trade" in which international investors borrow for nothing in Japan and buy assets elsewhere. It could also encourage Japanese people to invest their money at home rather than abroad on the expectation of higher returns.

Through a series of steps - the end of the carry trade, less investment in US assets, higher yields on Treasury bonds, more expensive US mortgages and falling US house prices - Mr Roach sees the end of quantitative easing as a potential catalyst for the bursting of a US housing bubble and a halt to consumer-led growth. This view, however, is far from mainstream.

In America's deregulated financial market environment, liquidity-related impacts show up less in the various gauges of the money supply and credit flows and more in the form of movements in real interest rates.
With the Fed maintaining a long period of unusually accommodative policy financial assets have been supported by a steady stream of "carry trades."
Stephen Roach, 5/9 2005

Between 1995 and 1998, a number of investors participated in the great "Yen carry trade". For three years, it was fantastic: whatever one bought with one's borrowed Yen, one made money
GaveKal Research at John Mauldin 25/7 2005

Needless to say, the US$ carry trade is no longer working. For a start, the US$ is no longer falling, and borrowing US$ is no longer free (the Fed just raised rates again). In turn, this raises an important question: will the unwinding of the US$ carry trade prove as painful as the unwinding of the Yen carry-trade?

The US$ carry trade is in the process of being replaced by the Euro carry trade.

The question then becomes: what will investors do with their borrowed Euros? So far, investors have been buying a lot of European government debt and a little b it of European equities. So what could trigger a change in this behavior?

Option #1: A real political crisis in Europe (i.e.: a threat by Italy to return to the Lira, or worse, by Germany to return to the DM) leads investors to shy away from EMU government bonds, or at least, to put a "risk premium" on EMU government bonds (European governments are the only governments in the OECD issuing debt in a currency that they can not print at will - a fact which should lead to some "risk premium").

Henry Kaufman:
Money matters but credit counts
John Authers, FT Investment Editor, March 15 2007

Dr Doom is back. Henry Kaufman, the legendary chief economist for Salomon Brothers in the 1970s and 1980s, earned his nickname for gloomy (and usually correct) forecasts of higher inflation and interest rates. He turns 80 this year, and gave a speech in Wall Street on Tuesday night.

The problem lies in the changing definition of liquidity. After the war, liquidity was an “asset- based concept” – companies’ cash on hand and so on. Now, Kaufman said, “firms and households alike often blur the distinction between liquidity and credit availability. Money matters but credit counts”.

Securitisation and improved technology, he said, stimulated risk appetites, “fostering the attitude that credit usually is available at reasonable prices”. But risk-management models assume “constancy in market fundamentals,” and do not account for the market’s changing structure.

The new chairman will need to make tough judgments on the housing sector.
For the new chairman the question will be: can households continue to serve as a stabilising force in the next recession or have they already been marginalised by the household debt binge?
Henry Kaufman, Financial Times, 2/8 2005

The central bank has raised its Federal funds rate 25 basis points after each meeting
It has contributed to a massive carry trade – borrowing in low-yield funds to invest in higher-yielding ones
Henry Kaufman, Financial Times, 2/8 2005

Since the inception of this approach several years ago, the central bank has raised its Federal funds rate 25 basis points after each meeting of the Federal Open Market Committee. Fed officials have tried to reassure market participants through frequent public utterances.
This approach has wrought several unintended consequences. For one, it has contributed to a massive carry trade – borrowing in low-yield funds to invest in higher-yielding ones. This is because investors have been conditioned to expect moderate and steady increases in money rates, which their quantitative analysis shows will pose limited risks, if any, along the yield curve. This, in turn, has led them to conclude that the carry trade can be the source of substantial profits. As a result, the yield curve spread has compressed significantly. Although spread compression typically yields smaller profits from carry trades, profits have remained high as investors have enlarged their positions.

In short, the Fed’s recent monetary approach, combined with the US Treasury’s practice of confining much of its new borrowing to short- and intermediate-term notes, explains a great deal of what the Fed has dubbed a “conundrum” – namely, the sharp increase in short rates in the face of declining long-term yields