The Hindu Business Line : Bond carry trade has few takers

Interest rates are at historic lows in the world’s biggest economies — the US, Japan, Europe and the UK, not to speak of the emerging economies of China (if it could be called that) and India.

The first consequence for financial markets is the demise of the carry trade in currencies. The large interest rate differentials between the US, Aussie and New Zealand dollar on the one hand and yen and Swiss franc on the other were extraordinarily attractive to borrow at near zero rates in the latter and invest in the high-yielders or their stock markets. Those opportunities are now gone.

Traders needn’t worry. The carry trade has opened up in bond markets.

In recent weeks, there has been a spurt in Government bond yields. Markets think an economic turnaround is under way. They have also taken fright at the relentless piling up of public debt to rescue and recapitalise financial institutions and finance stimulus packages. Indeed, bond guru Bill Gross thinks the US could lose its ‘AAA’ status thanks to fiscal profligacy.

Also being argued is that inflation can’t be distant. One analyst believes inflation-protected Treasuries (TIPS) — which compensate investors for the rise in consumer price indices — are a screaming buy as their prices don’t reflect the prospect of increasing inflation.

The result? The spread between long (10 years) bond yields and short rates has widened to 3.5 per cent levels in the US as the market factors in an economic recovery and inflation risk even as the Fed keeps rates close to zero.

The picture is similar in India. Ten year governments return about 6.5 per cent, while they can be financed at 3.5 per cent or less.

Yet it doesn’t seem the bond carry trades are anywhere near the size of the positions built in currency carry trades at their peak with yen financing.

Obviously, the market is not confident that the soft monetary policies of central banks will continue long enough for the trade to exit at a profit. This, despite the Fed assuring markets that it will keep rates low till it is certain of an economic and, equally important, in current circumstances, asset price recovery.

Of course, no central bank can offer a free ride indefinitely or a blanket promise that it will not raise rates for a specific period. But, the Fed Chairman, Ben Bernanke, has not dared to even hint a policy reversal, lest he unwittingly roils touchy markets.

The RBI Governor, Dr D. Subbarao, seems satisfied with current rates. He is probably concerned about the over Rs 100,000 crore of liquidity in the banking system turning inflationary. A policy group, headed by the Cabinet Secretary, sees no need for a further fiscal stimulus (but the new Finance Minister is talking of measures to improve the growth rate).

Understandably, the market thinks the bond carry trade is fraught with risk.

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