https://medium.com/@yuanyao89/the-feds-franken-bull-f0e84c7d61f9 … (original article with graphs n shit)
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Post 2008 GFC: low interest rates & pumped liquidity for firms to invest in real growth. These conditions lent to creation of the "carry regime,"
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"we define all carry trades to share certain critical features : leverage, liquidity provision, short exposure to volatility, and a “sawtooth” return pattern of small, steady profits punctuated by occasional large losses (p. 3, LL&C)."
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examples: "undertaking classic currency carry positions , writing insurance or selling credit default swaps , buying higher — yielding equities or junk debt on margin , taking out buy — to — rent mortgages to finance property investments , to writing put options on equities or...
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...equity indexes or buying exchange — traded funds that do so — but that is not all . Carry trades can also include dealings such as companies issuing debt to buy back their own equity or private equity leveraged buyouts, plus a whole gamut of more complex financial strategies.
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Classic carry trades use borrowed money to take positions in high — yielding assets with less liquidity . This is precisely what private equity funds that focus on leveraged buyouts do . Use debt to purchase a portfolio of companies with yield above the cost of debt (p. 78, LLC).
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Here's the spicy part about the Fed shorting vol Since selling volatility is providing leverage and providing liquidity, the most important volatility seller must by definition be the lender of last resort (p. 101, LL&C).
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If the Fed is seen as the greatest volatility seller, then the claim that volatility selling is extremely important to the stock market is closely related to the quite conventional claim that the Fed is extremely important to the stock market (p. 101, LL&C).pic.twitter.com/YPY5Hx9TGL
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The idea that the stock market rose so much over 2013–2014 purely because the Fed pumped so much money into the economy is not credible (p. 102, LL&C).
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The Fed is carry trader and the S&P500 is a carry trade: The true reason that the US stock market rose is that the S&P 500 has become a carry trade and the Fed’s QE policy represented a massive selling of volatility. The Fed became possibly the biggest carry trader of all:
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its balance sheet is a huge carry trade with large holdings of yielding securities, such as Treasury securities and mortgage-backed securities, financed by very low-cost liabilities including zero-interest cost cash currency in circulation (p. 103, LL&C).
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The carry regime creates an illusion of liquidity: this expectation of ample liquidity runs counter to what has actually transpired when consensus views have changed and investors have sought to reposition their portfolios accordingly. In May–June 2013, when Chairman Bernanke
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uttered that famous word — “taper” — and raised questions about the Fed’s continuous support for markets, many investors were unable to complete their desired transactions for even the most vanilla-type securities (p. 115, El-Erian)
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Remember how carry trades involve leverage: carry traders are often forced to close positions when prices move against them. This necessarily means selling assets that are falling in price (or buying assets that are rising in price). Thus, the dynamics of managing carry trade
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risks create fire-sale effects in which initial movements in prices are often substantially amplified. The expansion of carry trades always increases liquidity; the reduction or closing of carry trades leads to liquidity contraction (p. 3, LL&C).
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This fact leads to a pernicious feature of carry. Leverage increases the risk of ruin, and carry involves leverage. Carry drawdowns are therefore likely to involve the risk of some participants facing ruin. This means the aggregate growth of carry is likely to represent a
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systemic risk to the financial system. It is therefore no accident that the increased involvement of central banks as lenders of last resort has coincided with the growth of carry. They are intimately linked (p. 72, LL&C)
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systemic risk to the financial system. It is therefore no accident that the increased involvement of central banks as lenders of last resort has coincided with the growth of carry. They are intimately linked (p. 72, LL&C)
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Chuck Prince, the former CEO of Citigroup, said: When the music stops, in terms of liquidity things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.
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