The carry trade is an integral part of global financial markets. While in the past we highlighted the relationship between the Yen and the stock market, the simplest form of the carry trade consists of borrowing money at a low interest rate in one currency and investing it at a higher rate in another currency.
Given it’s deep liquidity, the US Treasury curve is a favored destination for flows related to the carry trade. When interest rates rise in the US it becomes increasingly attractive to borrow money in a cheap currency (such as the Yen) and use the proceeds to finance the purchase of a Treasury bond. For example, late last week yields on the US 30 Year Treasury bond rose above 2.5% for the first time since mid-January. At the same time the value of the Yen fell sharply against the dollar.
The relationship between the Yen and…
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Look at the heatmap above: it shows the 1 minute correlation matrix for the US interest rate futures complex including the first 16 Eurodollar contracts and the Treasury curve. Unlike heatmaps of the stock market, this matrix is smooth from cell to cell: note the beautifully sloping gradient from the front end of the curve (GEH5) to the back (UBH5). No one would blame you for thinking that any market with such an ordered correlation structure must be one of the most efficient in the world.
As the second chart shows, however, the market has a funny way of shattering consensus opinion. Buoyed by the prospect of QE from Europe and stagnant prices at home, US Treasury bonds had begun to enter bubble territory. Short term interest rate traders bid up the price of Eurodollar futures, pushing back their expectations for the date of the first rate increase.
But early this week the…
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