Unwinding the carry trade & Delta hedging -- forces keeping the yield curve flattish

The wailing and gnashing of teeth is upon us! People have been declaring that the inverted yield curve (now the flattish yield curve) foretells the apocalypse. Historically an inverted yield curve comes before a stock market collapse so people are getting very excited about a possible stock market crash. Right now, though, there are several natural market forces pushing down the yield on the long term bond, so I believe that a hard-nosed investor shouldn't be worried by the rate curve.

1) Unwinding the carry trade: During the last few years (maybe 2001-2005) a lot of hedge funds took note of an odd international fact: one could borrow short term money in Japan at less than 1% interest, and one could loan long term money in some places (like Iceland or the middle east) at 5-8%. So the carry trade became very popular. The hedge fund would sell bonds short in Japan (paying the 1% interest) and buy bonds elsewhere that pay a higher rate -- making money on the difference. The move is not for amateurs though, because if suddenly the yen and kroner currencies reverse you might not be able to pay back the money you borrowed, but modern finance markets make it possible to make all these moves in dollar denominated instruments, at the cost of some of your income.

Now we fast forward to the present (2006) and interest rates are finally rising in the US and Japan and it's time to unwind the carry trade before a widening yield curve takes away all your money! If you recall, the borrowing was done with short term money and the lending was done in long term markets. So to unwind the carry trade you buy short term bonds and sell long term bonds. Bingo! The hedge fund who invested an estimated US$12 billion in this strategy are all pressuring the yield curve to flatten out or invert.

• Scenario: People unwinding the carry trade in large numbers
• Outcome: Market push to flatter or inverted yield curve

2) Bond Delta Hedging: For the 99% of people who never have a thought about delta hedging, please forgive the jargon and allow me to explain briefly. There is a strategy where you buy a long term bond and then sell short some number X of short term bonds to pay for it. The value X is actually indicated by the greek letter delta, giving the strategy it's name "delta hedging." As the yield goes up and down the value of the two bonds varies in relation to each other and you sell a few more short bonds when the price goes up and buy a few back when the price goes down. This position makes money on rate volatility. (The related strategy of stock delta hedging makes money on the stock price volatility). So why doesn't everybody do it? Well, the profits are typically small enough that transaction fees make it non-profitable for everyone except the market makers who have their own exchange access, so normally those are the people who hold these positions. As the volatility goes up the position becomes more profitable and for some time now the trade has been profitable enough for large trading hedge funds to make money at it.

• Scenario: Delta bond hedging because the changing rate picture induces bond volatility
• Outcome: Delta bond hedging position requires buying long term bonds and selling short term bonds, market push to flatten or invert bond curve.
• (For more on delta hedging see Principals of financial engineering, by Neftci around page 246. I've put a link to the book on amazon in the right side links collection.

So all of this means that there are several very definite supply and demand forces pushing down long rates relative to short rates that should keep the curve surprisingly flat for a while. Look for the curve to become steeper after the hedge funds unwind their positions and once the fed stops raising rates, reducing volatility.

And what about the conventional wisdom that says an inverted curve predicts the falling of the market? My take on it is that inverted curves should happen historically as the fed raises rates (for the reasons above) and during an economic cycle the fed often raises rates until the market falls. Thus the inverted curve is a symptom, not a cause, and we're better off watching causes because they are better predictors. I wouldn't worry too much about the rate curve smashing the market, I would only watch the rate curve to make money off it!

So how do you make money off what we just talked about? Well, if we now assume that sometime in mid to late 2006 (for example) the fed were to finish up with rate increases (lowering volatility) and the hedge funds were to finish up with unwinding their positions then we would finally see the curve steepen. We could make money off inverse bond funds at that point and I, for one, am keeping a close eye on the RYJUX ticker (Rydex inverse bond fund). Buy some of this when the market forces stop flattening the yield curve and you could make money while the yields are rising, then convert it all into high yield bonds and ride out any market crash.