Q&A with Todd Yoder: Carry trade bubbles, risk and negative interest rates

Fluor is a leading engineering and construction company that operates in all corners of the world, with the business requiring a multifaceted approach to risk to navigate an increasingly uncertain global economy. The Global Treasurer spoke with Todd Yoder, managing director of corporate finance treasury at Fluor, to discuss carry trade bubbles bursting, his approach to risk and the limitations of interest rate modelling in a negative rate environment.

Do you think that corporate treasurers are looking at carry risks closely enough to understand the potential short-term and long-term risks to their businesses?

No, I have been fortunate to know many corporate treasurers over the years, and I confidently say I do not know one that would say they have all carry related risk mitigated. After nearly 20 years in corporate finance and more than 10 years running derivatives and hedging strategies, I still see corporates that are carrying a significant amount of foreign currency (FX), interest rate, and commodity price risk that remains unmitigated.

Frequently I hear how well treasurers are managing balance sheet remeasurement FX exposure successfully, but they are missing what I call the “silent killer” the cash flow FX exposure. The reason I think this continues to be a challenge is that the balance sheet remeasurement FX impact shows up in a separate line in the financial statements, while the cash flow FX risk usually becomes transparent when companies see unfavourable impacts in margins they cannot explain away. FX is much easier to manage as compared to some of the even less transparent hard to forecast carry risks.

In 2021, market dynamics make the role of treasury even more critical than ever to the business – the treasurer needs to have the same great depth as always, but a lot more breadth is required to truly understand the risks the business may encounter and carry risk can be significant both short-term and long-term.

Today’s risk is so multifaceted that corporate treasury needs to look at risk in much greater detail, and utilise all tools available including alternative data, market signals, and machine learning.

Looking at the past to try to predict the future is not enough. The known-unknowns are one thing, but the unknown-unknowns are where the right treasurer with good breadth and a proactive approach can make all the difference.  My view was reinforced late last year when I asked Nassim Taleb about corporate treasury risk management – his response was to “use extreme value theory,” which is great advice.

What are the potential short-term and long-term risks with carry trade bubbles and what is an example of tricky areas treasurers may come across when facing decisions that involve the use of carry trades?

The easiest carry trade to understand is interest rate arbitrage – borrowing capital in a low-interest rate currency and investing that capital in a higher-yielding currency – collecting the spread between those two different interest rates. If the FX spot exchange rate remains stable or moves in the trader’s favour (funding currency depreciates), the strategy is profitable – where the trader gets into trouble is if the funding currency appreciates against the currency invested in.

Corporate treasurers typically have policies against any speculative trading; however, a treasurer could find themselves facing a less obvious carry scenario when borrowing in a lower interest rate currency and then investing those funds in assets in a different currency, perhaps a manufacturing facility. The business should consider how much free cash flow the FX asset is going to generate, in what currency(ies) will the asset generate cash, how long do they plan to own the asset, and will the relative value of the asset be impacted should there be a sharp decline in the local currency of the asset.  If the business needs to liquidate the asset, how will a change in FX rates impact the transaction. Another area is asset and liability fix-float mix – volumes, duration, volatility, re-pricing risk – if you are long fixed-rate debt and interest rates move lower and you have lower interest income and your unhedged fixed-rate debt isn’t marked-to-market.  The most common carry trade over the past 10 years has been share repurchase many times in conjunction with a debt transaction – the organisation is borrowing at some rate and investing in its own shares – this increase in leverage works out well as long as the organisation performs well.

Corporate treasurers’ objective is to mitigate risk, while money managers running levered portfolios employ more complex strategies whereby their objective is to make a return and not to mitigate all risk. These money managers are buying and selling volatility and providing liquidity in many cases – treasurers need to understand how these market participants are trading to get a better grasp on real money liquidity risk, conversion risk, and counterparty risk to name a few.

I would point to USD/CHF as a good study of why treasurers need to understand the non-corporate trading activity.  There are hundreds of different variations of options strategies carry traders utilize. Some may have spot FX risk protection and be long and short different parts of the forward curve, but at the end of the day if you are not taking some risk there is no profit. Those trading for a profit use their proprietary models that give them an advantage, which may be true for a period until such point that it is not. The adage of “picking up pennies in front of a steam roller” comes to mind – sometimes the pennies may be more plentiful, but the stream roller may be moving faster.

In a blog post by RiskQuest, a consultancy firm that specialises in smart risk models, explain how “not all interest rate models are able to deal with negative interest rates”. With treasurers not wanting to be on the wrong side of central banks’ rate decisions, are treasurers at risk of seeing a carry trade bubble bursting?

This is a great article, even if treasury has a solution for negative rates in place it certainly doesn’t hurt for treasurers to proactively think through all business contracts and reference rates. Additionally, I have seen some language specifying zero-bound rate references in contracts – this should be on the radar.

I would point your readers to the book “The Rise of Carry,” written by Kevin Coldiron, Tim Lee, and Jamie Lee – there are some great examples of carry trades and concepts corporate treasurers should be thinking about. I did a review of the book that can be found at EuroFinance blog post (March 2020) which may be useful when thinking through this question.  It comes back to the quote I made in the article, paraphrasing Warren Buffet, something to the effect of “no one knows who is swimming naked until the tide goes out”.

In today’s environment, I think it is more important than ever before that treasurers ensure they have an in-depth understanding of the macroeconomic environment. My interest in macroeconomics began in graduate school when I was exposed to work done by Jeffery Bergstrand with economic integration agreements. I’ve also looked at many different economic theories including the more popular Keynesian, Austrian, MMT – and have even discussed Marxian economics with Yanis Varoufakis. Treasurers need to understand a variety of different economic views to form a more holistic view of the risks their business may face. For treasurers, one economist and former hedge fund manager that I think is making a lot of sense right now is Hugh Hendry – I would recommend an article he wrote titled “The Dawn of Chaos”. Hugh has a great history and provides thought-provoking perspectives that are sometimes different from mainstream narratives.

High leverage and easy money have created many situations in the past that treasurers can learn from – Japan from the 1980s is a great place to start and studying the Asian currency crisis and the impacts of emerging economies borrowing offshore in one currency to invest in a different driving credit expansion in both currencies and how export-dependent economies are vulnerable to sharp and sudden moves in rates.  I have observed several currency devaluations over the years – not as many revaluations. Then you have the US with the world reserve currency (which I do not see changing anytime soon) that layers a different complexity on top – one being the responsibility to provide USD liquidity to the world via the Eurodollar system.

In an increasingly connected world, major macroeconomic events are more frequent does this demand treasurers provide a more predictive and proactive approach to risk management, whereby teams focus on the future more than the past?

The most successful corporate treasurers moving forward in an uncertain global economy will be those that prioritise some time and investment into alternative economic views in addition to the mainstream, think futuristically, utilise technology to gain transparency and model scenarios that could occur and not just what has occurred historically.

As treasurers, we have always had to be forward-thinking – we are in a dilemma because predictive power works best when volatility is lower, but the risk is highest when volatility increases. As corporate treasurers, most are not speculating as a hedge fund would, so we stay disciplined and vigilant about monitoring and modelling macro events and counterparty risks.  The need for more transparency is increasing as treasurers want a better understanding of their carry risks. The good news is technology isn’t just advancing it is accelerating, which brings great opportunity for the treasury discipline to add great value to the business. Risk-intelligent decision-making is here and being embraced more every day.