“Nobody in their right mind wants to own the ten-year bond at a two percent interest rate. But they’re doing it because they can borrow overnight money for free, ten basis points, put it on repo, collect 190 basis points a spread, and laugh all the way to the bank. And they will keep laughing all the way to the bank on Wall Street until they lose confidence in the Fed’s ability to keep the yield curve pegged where it is today. If the bond ever starts falling in price, they unwind the carry trade. They unwind the repo, because then you can’t collect 190 basis points.”
It’s really the part about using a repo as a carry trade that I don’t understand. Any clarification would be helpful. Thank you very much.
The investor borrows by issuing overnight repos which he renews each day. He pays 10 basis points to borrow overnight money because the Fed has pushed the Fed Funds Rate to that level. He then invests the funds in T-bonds paying 200 basis points and earns 190 spread. If the bond price begins to fall (i.e., its interest rate begins to rise), he loses capital on his investment. So, he sells and then pays off his repos instead of renewing them.
Stockman calls this “carry trade” because the investor is aiming to earn the spread between interest rates but faces the possibility of losses from adverse movements in bond prices just as the carry trade in foreign exchange seeks to earn an interest rate spread but can suffer losses from adverse movements in exchange rates.