The Global Carry Trade, Alchemy, US vs China

September 17, 2020

"The fool doth think he is wise, but the wise man knows himself to be a fool." 

- William Shakespeare

The more you seek the uncomfortable, the more comfortable you will become 

- Conor McGregor 

Never wrestle with a pig because if you do you'll both get dirty but the pig will enjoy it 

- Charlie Munger 

Did you watch this guy last night?

Jerome Powell, the head of the Federal Reserve indicated that it would not raise interest rates until inflation has been higher than 2 per cent “for some time”. They predicted that interest rates would be close to zero until at least the end of 2023.

To make sure you believed him, he used the word “powerful” a lot.

What does all of this do to the carry trade?

In finance, a carry trade is typically thought of as an interest rate arbitrage expressed as a trade between two currencies, where the more historically stable currency is used to fund the purchase of an historically less-stable but higher yielding alternative in exchange for taking on currency risk.

Another example would be being long high yielding assets and financing them through cheaper borrowing.

Today the carry trade is global and across asset classes. The FED creates money that eventually drives up asset prices. 

But can the FED run out of ammunition and what does that mean?

Some ideas I hear on how it could end:

1. We borrow so much GDP from the future that trend economic growth is zero.

2. Both real and nominal rates go to zero.

3. Investors lose faith in the underlying currency the assets are denominated in.

As you contemplate the global carry trade, I recommend checking out this book:

Or you can listen to the authors on this great Hidden Forces podcast.

We covered the book here.

B. Perception Is Reality

One of my favorite people is Rory Sutherland, last year he wrote a book titled: Alchemy - The Surprising Power of Ideas That Don’t Make Sense. 

He’s currently the Chairman at Ogilvy and started their behavioral science practice. 

The big idea behind Rory’s work is: turning engineering problems into perception problems. His thesis is that we don’t perceive reality as much as our interpretation of it. 

The same food tastes better if it's expensive and in a dimly lit fancy restaurant with fancy plates and cutlery. When it comes to our happiness, money has higher ROI improving the lighting and adding fast WiFi to the tube or Eurostar journey, than trying to make the journey faster. 

Perception is reality.

In business there is a natural tendency to fall back on economic explanations for behaviour, and not to look for deeper, messier psychological explanations. Once we have a plausible, rational explanation for something we basically give up and do not look for “the real why.” 

The real why is the deep, unconscious, often unexpressed, unknown driver behind a particular behaviour as opposed to the surface ex-post rationalisations that we construct. Often, we don’t even ask about the real why for fear of asking awkward questions or making ourselves look silly.

There is also a huge incentive to pretend there's a single right answer to a question and then to act as though you have identified it. That way you never get blamed if things go wrong: “it's much easier to get fired for being irrational than to get fired for being unimaginative.” And so business clings to this kind of very deterministic balance sheet model of the world where business becomes an efficiency optimization problem.

The underlying thesis of Rory’s book, Alchemy, is that if you change the frame of reference – the contextual frame of comparison upon which people are drawing – you can make expensive things seem cheap and rubbish things seem good, without changing the products themselves, or their cost, at all.

Rory talked about an example of narrow thinking which initially seems successful, but then turns out to be costly. If you define the function of a hotel doorman as opening the door of the hotel, you will replace him with technology or an algorithm and confidently declare savings of $35,000 a year. But the real role of the doorman is around guest recognition, security, hotel safety, hailing taxis, etc. – the door opening part is likely only 10% of his real value, which is more symbolic and psychological, not functional.

One or two years down the line there is a vagrant sleeping on the hotel stoop and its prestige falls, the real costs of doing away with the doorman emerge. But consultancies often promote this kind of narrow, functional approach: “there’s this incentive to essentially ask narrow questions because it helps us make sense of the world and we crave the illusion of certainty.”

Ask Why at least five times, before settling on an answer.

Rory was recently on the Invest Like The Best podcast, which is a great listen.

C. A Few Things Worth Checking Out:

1. The End of the Last, Best Chance: great discussion on the future of US / China relationship by Peter Zeihan.

2. Stripe: The Internet's Most Undervalued Company.

3. Will Danoff, who runs Fidelity’s Contrafund, $110bn in assets (and probably the largest active equity fund) was on the Masters in Business podcast discussing how he finds opportunities and what he’s learnt over three decades.

4. Michael Taylor is the CEO of MicroStrategy, the first company to decide to hold their balance sheet in Bitcoin ($425mm decision) rather than USD. He was on the Pomp Podcast discussing this discussion.

5. New High for Multi-Generational Living: 52% of adults aged 18-29 now live with their parents, up from 47% before the pandemic (it appears that about one quarter of the increase is due to college campuses being closed down in the spring). The last time the percentage was this high was in the 1930s – during the Great Depression – when it peaked at 48%. The numbers hovered around a 29-32% trough in the 1960s-1980s before beginning a steady climb up. They were jolted higher to 44% in the financial crises a decade ago.