Stock market and carry

Stock market and carry trades currently look to be linked in a manner not previously seen. When the stock market rallies, there is a pop in riskier high yielding currencies. However inferences on the link should be carefully considered.

There has been more research talk about the beta in carry trades and that high yielders are related to macro variables as measured through the consumption CAPM and also through a changing risk premium that is accentuated in market downturns. That is, the beta or correlation between high yielders and the stock market increases when there is a big market move. The argument also states that low yielders have a negative consumption beta and outperform when we have a fall in consumption. The risk premium in high yielders are counter-cyclical like bonds and equities.

Nonetheless even a simple review of the relationship between equity prices and high yielders is more complex that what some may think. Certainly, the story of higher betas for higher yielders does not fit the facts over the last two business cycles if we look at a carry portfolios and stock indices.

We take a very simple diagram of a carry trade index and three major stock index, the S&P 500, the MSCI EAFA and MSCI World. The graph provides two contrasting positions on the relationship between equity returns and carry. First, there is a strong positive relationship between carry and equities during the current credit crisis. Both have moved down significantly albeit the carry actually faired much better.

However, if we look at the carry trade during the equity downturn during the last recession in 2000-2001 you get a very different story. Here carry was able to ride through the recession and provide a good alternative source of return. The story that high yielder will be tied to an equity or consumption beta does not hold and the graph shows the opposite result.

Equities cannot provide a good measure of risk for carry. There has to be a unique factor that applies to both stocks and carry to explain the more recent relationship. The alternative story is that carry returns are related to liquidity risk. This may be more consistent with the facts because the recent stock market sell-off has been a global liquidity problem while the earlier equity downturn was the unwinding of the technology bubble. In that case, the monetary authorities provided significant liquidity to the financial markets which was taken and used to invest in new trades including carry and real estate.

Carry is a liquidity trade and to the extent that liquidity becomes scarce for both equities and carry, there will be a fall-off in both. Without a liquidity event, they will move in their own directions.