Is US Dollar Carry Trade a Menopause in the Currency Markets?

March 12, 2015 March 12, 2015

I had taken my then life savings earned from a job pushing shopping trolleys at the supermarket, and sent them overseas with a friend.

I was 16 years of age and my life aspiration was to travel the world. Id figured out that to do so Id be needing (strong) foreign currency. My friend banked my money in Australian dollars and this was to be my very first major currency trade. I was long AUD/ZAR  a great trade for me over the following few years.

I would look up the foreign exchange rates in the back of the newspaper my Dad brought home each night and Id quickly calculate my P&L.

This was my first experience with currency volatility and the ride was more uncomfortable than the notorious Cresta run.

Id remember feeling elated when my holdings had increased showing me a profit, and terribly depressed when the inevitable opposite happened. My moods could probably have been easily predicted by that one currency pair.

Many years later Im the proud husband of a beautiful wife and this is where Ive realised that understanding currency markets is the key to understanding women. I knew currency markets before I knew women so I think I had a heads up. No excuses, heh!

The ancient Greeks first attempted to explain mood swings over 3000 years ago but only in the last century did psychologists begin to figure out that we humans go through cycles from birth. These depend on the level of hormones pumping through our bodies at any given point in our lives. Husbands all over the world have to deal with this once a month. At least we know whats coming and we can prepare by retreating to our man space to retain sanity.

Just the other day a male friend of mine was telling me about why hes spending so much time on the golf course lately. It turns out there is a correlation between time spent on the golf course and his wife hitting menopause. One minute everything is fine and the next his wife is a slobbering, weeping wreck with the psychological stability of half set jelly.

I was curious so I looked it up and lo and behold, between the ages of 45 and 50 women go through this. Thank God Im male but imagine that. Its predictable to within a 5 year window!

Which does beg the question: where can we find such predictability in the markets?

When looking at short-term cycles we have the business cycle which lasts roughly 5 to 8 years. Then we have longer term cycles such as the long-term debt cycle, secular cycles and so forth. The important thing to understand is not that these cycles exist, as any half decent macro investor understands this, but to understand what drives these cycles, what the catalysts may be causing them to rise and fall and then to further figure out where we may be in any given time-frame in any given market.

In short, its probably worth knowing when your wife may be hitting menopause so you can prepare accordingly. So too its valuable to understand what cycles were in when looking at global financial markets. Today as I write this we have MASSIVE warning signs in the carry trade. Something I detailed last week here and which we delve into with great detail in our US Dollar Bull Market report.

Last week I answered (or at least I hope I did) a readers question around how the massive US dollar carry trade has reached over $9 trillion. My  answer   hopefully showcased that were dealing with a cycle here.

This brings me to another question brought to us by a reader:

Dear Chris and Brad,

First of all I would like to express all my gratitude and admiration for you and your newsletter. I am working in a large Real Estate buyout firm in London, but your pieces made me re-evaluate my career path and look for a more entrepreneurial path within the investing space; I thank you for that.

I am contacting you as your articles on China and the Yuan has captured my interest and I have to agree with all the points you make. My only concern, is that a long USD/CNH trade entails a negative carry of

3% p.a. which makes the timing of the trade very important (given the 3trn+ USD reserves, could the PBoC delay even further the breaking of the peg while continuing with monetary easing?).

I was wondering what are your thoughts on a long position in USD/TWD instead; it has a very low cost of carry and benefits from the majority of the dynamics seen for the USD/CNH. What are the drawbacks/offsetting factors to the long USD/TWD trade that I am not considering?

I put this to Brad who responded.

You are correct with the USD/CNH being a negative carry trade. However, this isnt a concern for us as this negative carry is built into option prices already. Furthermore, we see this negative carry narrowing over the coming months as the US begins to lift rates and China continues to cut.

Lastly, in terms of timing if time is cheap then timing the market is not important. Call options on the USD/CNH are extremely cheap. So given that we think that it is almost a certainty that the renminbi will devalue against the US dollar over the next couple of years we think that it will prove very costly to try and time the big move in the renminbi. So we will buy long term calls on the USD/CNH and continue to buy ourselves more time until the move gets underway.

As far as the TWD goes we dont really have any definite view on this currency (in any event we think that if we get the USD/CNH right then the payoff will more than suffice). Our other big call is for a material depreciation in the Singapore dollar (upside in the USD/SGD). This is already playing out with our option positions up some 500% in the last 12 months.

Thanks for reading and have a nice weekend. Perhaps playing golf?

- Chris

In fiction: we find the predictable boring. In real life: we find the unpredictable terrifying. Mokokoma Mokhonoana

This Simple Strategy Could Have Potentially Saved Billions

March 11, 2015 March 11, 2015

Deal making is glamorous. Apparently

When I tell people what I do in private equity I get strange responses. Oh, that sounds so great, so glamorous, while the head rolls back and people look at the sky, perhaps imagining all the glamour.

Maybe they are thinking international travel, negotiations in board rooms with expansive views over exotic cities, big fish tanks and million dollar artwork adorning walls. Or maybe lobsters at swanky restaurants topped with Moet & Chandon. I dont know but I assure you its nothing of the sort.

Actual deal making is only a small part, usually the little bit at the very end. The icing on the cake, the sealing of the envelope, the final handshake, so to speak. But, and this is the point, nothing ever gets to that point without due diligence .

The guts of any private equity deal is to be found in the due diligence process. Due diligence is the bacon and egg in a bacon and egg pie. Without it youre just left with fluffy pastry which makes you fat.

Anyone focused on deal making to the exclusion of due diligence is exposing themselves to undue risks. Private equity investing is probably not dissimilar to being a teenager engaging in hanky-panky with the girlfriend while the parents are out. It can be quite rewarding but the risks are high and getting caught with your pants down could be, well  catastrophic!

Due diligence is more than probing the numbers to see if theyre correct or in the case of projections, something we deal with a lot in early stage companies, its about thoroughly investigating the strategic rationale for a business.

When it comes to the latter point I like to think of this as periphery due diligence . This is where you look beyond the numbers but really put them under the microscope with context. Part of this process is in searching for unreliable or unreasonable assumptions, flaws in logic, or inconsistencies in either the business plan or in what we as investors are being presented. This needs to be done objectively and as is often the case, in the event that even after many months of due diligence, money and time spent finally walking away if the risks are to high.

What happens when due diligence is ignored or faulty

Take a look at literally any sector that is hot in M&A and I guarantee youll find acquisitions which add little value or make absolutely no sense at all being made. Matchmaking made in hell.

What happens, I think, is middle aged men in shiny shoes and tailored suits forget who they are, and regress to thinking like teenagers fueled by Iron Man movies and lacking any worldly experience. Ive seen senior management in large corporates target a particular company for acquisition. All sense leaves their head and theyre back in 16-year old bodies trying to chase the same basketball, ready to elbow any competitors should they get near.

War is a great motivator and senior management, instead of taking out some aggression with a decent round of paintball on the weekend with mates, suddenly see their chance to become the Chinggis Khan of the corporate world. Context and reason go out the window.

Sure, youll see companies go through all the motions of doing DD. A slew of analysts will be appointed to analyze the target companys books but really what theyre doing is just verifying data. The decision to buy has in fact already been made.

You should never have decided to buy BEFORE due diligence is completed!

That is like deciding to marry before dating.

Senior management is often just waiting for validation from quants in order to do what theyve already decided theyre going to do. They already have played the video in their head and theyre successful, on the front page of business journals and the envy of all at the golf club. Quants, on the other hand, are solely looking at numbers and sometimes not even that. Context is thrown out of the window. Periphery vision is nil. Nobody is really throwing rocks at the company treating it as if its a make or break component.

Speaking of being caught with ones pants down, consider some of the senior management teams that have been caught up in hubris, arrogance and lack of periphery due diligence:

• Bank of America and Countrywide Financial: Remember the bargain basement price BofA paid for Countrywide? $2.5 billion to pick up $40 billion in losses. Nice!

• An excellent example of complete lack of periphery due diligence can be found in AOL and Time Warner merger. AOL paid $164 billion leading to losses of a whopping $99 billion the following year.

• Then there was the RBS merger with ABN Amro. Horrendous!

The above are wonderful examples for anyone to investigate, should they care to. But it wont stop this process from repeating itself again and again.

There are any number of reasons why mergers and acquisitions can fail. Sometimes its a corporate culture clash, other times its an industry at its peak and the merger of two troubled entities simply exacerbates rather than reduces risk and failure.

I do wonder, however, how often hubris, arrogance and plain stupidity play a part. Stupidity, along with the cockroach and the AK-47, are the most indestructible things on earth. Theyre always going to be with us.

When it comes to evaluating a deal, and this goes for any deal, fully understanding the motives, desires and REAL aspirations of the target company is of paramount importance. This is true whether youre looking at a corporate merger or investing in private equity.

Once youre OK with setting your ego aside, looking for context in each deal and evaluating a business accordingly means youve solved more than half of the battle. This is a battle between your own ears more than anything else.

Id like to share with you a very simple technique which weve found valuable.

One of our partners in Seraph. uses this technique when running due diligence. I first witnessed this over 2 years ago and now use it regularly. He asks particular questions more than once. This may sound trivial but I cant tell you how many times its been a lifesaver and revealed important elements in the business.

There are always going to be questions or topics which elicit a response that is too hasty, too contrived or maybe just outright awkward to answer.

What you have to do is to ask a question and then later on in conversation ask the same question again but in a different context. You then have the ability to compare answers to see if theyre congruent.

Let me give you an example.

On a deal I was working on I had been discussing with a CEO his personal time commitment to the company. The gentleman was on holiday when we managed to meet. He was adamant that he would do everything it took to make the company work, including working 24/7. Sacrifice was no issue whatsoever.

In a second and far more casual conversation over drinks he told me that his wife was pregnant. I had already ascertained that he did not yet have any children or other commitments other than his business. The conversation went something like this:

Me: Wow, thats awesome. Thatll be an exciting change in your life.

Entrepreneur:  Absolutely! I am looking forward to spending as much time as possible with my wife and baby. My wife also wants to move out of the city to a more stress free environment.

Me. Are you going to move?

Entrepreneur: Sure, we are thinking of moving out here [here was an island in Thailand], I just need to get this company funded so I can employ some staff to take care of the heavy lifting for me.

Had I asked the same question regarding his commitment to the company in a slightly different way Id have got a completely different response.

In a separate deal which we were conducting DD on in late 2013 we asked a company about their inventory situation and delivery time for their product. After getting the answer we later asked for more detail around the processes involved in the manufacturing process. The answer received immediately showed us that the earlier answer couldnt have been correct since there was a gap in timing. As it turned out the founders were lying to us. They were telling us what they believed we wanted to hear.

When companies are less than truthful that is an immediate elimination. We never go back to the table no matter what. Management is THE most important aspect. bar none.

The one thing that I have to keep reminding myself of is that you never HAVE to invest .

The deals need to come to you and make sense.

- Chris

Trust, but verify. Ronald Reagan