Is Goldilocks getting carried away?

Not too hot? Not too cold?

Goldilocks

Not since kindergarten have I heard so many grown-ups talking about Goldilocks.

Every strategist I see on CNBC and Bloomberg loves to rave about our beloved blond adventurer, whose signature aphorism has become a metaphor for the relationship between the Fed and the market. It's simple: as long as economic growth remains "not too hot... and not too cold," central banks should keep rates low, making risky assets (like stocks and corporate bonds) more attractive. Slowly but surely, prices continue to rise until all the bears (on Wall Street) retreat to their caves. We can all sleep tight.

I love Goldilocks just as much as I did when I was a kid. It's a pretty compelling story. The correlation between the Fed's balance sheet (a proxy for easy money) and returns on the S&P 500 is around 0.93, according to Dean Maki of Barclays, and the same relationship applies to other risk assets, such as emerging market bonds and real estate. Moreover, Chair Yellen keeps insinuating that the Fed won't raise rates until the labor market improves, which still seems a few quarters away.

But before we power down our terminals and dip our spoons into the bears' porridge, we should take heed of another factor driving the ongoing rally in risk assets. It doesn't fit neatly into a fairy tale, but it's a story we've seen play out many times before -- and it usually has a horrific ending.

Beware the carry trade

It's called the carry trade. For those who haven't heard of it, carry trades work like this. Imagine you could borrow Japanese yen for 1 year at an annual interest rate of 0.05%. Say you borrowed a ton, exchanged it into Australian dollars, and invested the proceeds in 1-year Australian government bonds, earning an annualized yield of 2.53%. Once your bonds mature, you'd exchange the proceeds for Japanese yen, pay off your loan, and pocket the difference. You've just made a profit (or carry) of 2.49% -- the difference between your borrowing rate and lending rate. That's the carry trade.

But there's a catch. Imagine the Australian dollar weakened by 2.49% over the next year. Your profit would disappear. What if it weakened more? You'd lose even more. That's the risk you run whenever you put on a carry trade. If your funding currency appreciates by more than the "carry" your profits turn into losses.

That's why exchange rate stability is critical to carry trades. It's also why currency instability can have far-reaching effects on asset classes with high expected returns.

I know what you did last summer

How far-reaching, you ask? Last April, markets started to question the effectiveness of Abenomics, the Japanese government's far-reaching program to reinvigorate its domestic economy. These worries sent shockwaves through the currency markets, amplifying volatility in the ordinarily tranquil Yen market.

Source: NYU Stern Volatility Institute

Carry traders responded to heightened volatility in a predictable and rational fashion, unwinding their positions and selling whatever assets they could in order to raise liquidity. Emerging market bonds were among the worst hit, with EMLC, a proxy for local-currency emerging market bonds, shedding almost 9.5% between April and July.

Source: Yahoo Finance

Last year's sell-off in emerging market bonds was just the latest reminder to beware when carry trades become too popular. And that's what worries me today. This next chart shows that demand for Yen from overseas offices (think trading desks in New York and London) is at an all time high. This is hardly a surprise. Japanese interest rates are still at rock-bottom and Yen volatility is extremely low. 

Source: Bank of Japan

Is this time different?

To be fair, there are plenty of differences between this summer and last summer, not least of which is Chair Yellen's apparent determination to avoid the communication mistakes that precipitated the taper tantrum. There are also a host of powerful economic and technical factors supporting valuations across asset classes. But I think there's a good chance an uptick in volatility (perhaps ignited by uncertainty around the Bank of Japan's next move) could hit portfolios in unexpected ways.

One way to hedge the risk of a disorderly unwinding of carry trades is to buy at-the-money calls on the Yen. It's a pretty good time to do it, with implied volatility at the lowest level since October 2012, and it's a direct hedge with no basis risk. I would also look to the Australian dollar, South African rand, Mexican peso and other emerging market currencies to put on synthetic hedges.

Source: NYU Stern Volatility Institute

Whatever you choose to do, the return of the carry trade should be on your radar screen. Goldilocks makes for wonderful bedtime reading, but don't let it blind you to those foreboding growls you're starting to hear from the currency pits.