By Joseph Lisanti We at Standard & Poor's believe the fed funds rate will rise from its 46-year low of 1% to 1.25% on June 30, on its way to 2% by the end of this year and to 3.5% by yearend 2005. In light of numerous signals that Fed officials have given in recent weeks, the market should easily digest the rate increases. Nevertheless, there is always the possibility that traders will surprise us.
For one thing, nobody knows the extent of the "carry trade," a curious money-making effort engaged in by institutions to take advantage of the spread in rates. It works like this: Borrow extremely short term at low rates and buy 10-year Treasuries, which yield considerably more. The profit is the spread between the cost of funds and the return on the notes. Since the borrowing must be repeated frequently, this technique becomes less profitable as short-term interest rates rise. When rates rise, some participants begin to unwind their positions by selling the Treasuries, which depresses the price of 10-year notes. That can create a double whammy for carry trade players who hold on. They not only see prices of their existing Treasuries fall, but they also pay more to fund the transaction.
Ideally, many carry trade practitioners have already started to unwind positions. But nobody knows for sure. If a large number of players haven't yet done so, there could be a squeeze as everyone rushes to exit at the same time. That could resemble what happened in the October, 1987, crash, when numerous market participants, comfortable that they were safe because of a risk management technique called "portfolio insurance," tried to exercise put options at the same time. Most of us remember that the result was chaos.
If a large number of players attempt to unwind positions simultaneously, the resulting spike in yields on the 10-year note could depress stocks. Will this happen? We don't think so. Could it happen? Yes. Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook