Adrienne is a financial services and fixed income professional who has spent her career in banking and consulting services. She was an Associate Director at Bear, Stearns & Co. in San Francisco where she specialized on fixed-income portfolio strategies for banks and other institutions. Prior to that, she worked as a Fixed Income Analyst for Goldman Sachs in New York.Adrienne is a CFA charterholder and received a Bachelor of Arts in Economics from Northwestern University.For a limited time, you can get a 10 day trial to Adrienne's newsletter. Simply send an email here with the subject "Adrienne Penake Free Newsletter Trial"

Watching the dollar rally and gold sell-off raises questions about if and when traders will begin to unwind their carry trade. Since unwinding the current carry trade will create dramatic volatility in the bond market and pain for investors, I wanted to take the opportunity to explain what the carry trade is and how it influences markets. What is the carry trade? Fundamentally, the strategy is to borrow funds on a short-term basis at low interest rates and invest in longer-term assets with a higher rate of return. Investors make money on the spread between their borrowing cost and earned rate of return on investment. For several months, short-term rates have been very low and even negative when considered in real terms (rate less inflation expectation). This trade is also greatly fueled by currency markets. The US dollar is weak and has been falling for nine months. (See commentary on how and why here) The carry trade can play out across currency markets (i.e. Yen carry trade – here’s a great foreshadowing article by Roubini in 2007) or within a single country across the term structure of interest rates. How it works: Traders expecting future US dollar weakness will enter into a short position in the currency and use proceeds to invest in other assets, such as higher-yielding bonds, equities, commodities or other currencies. The problem with the carry trade is when spreads are profitable, it gets very crowded. When a trade is overcrowded, risk begins to be mispriced and an alternative asset bubble is created. Right now, we see the alternative bubble in commodities and arguably equities. More pressing, however, is that since this is a leveraged strategy, the unwinding of the carry trade exacerbates the volatility of rates and currency moves at a given inflection point. Most traders think they can “get out” before everyone else and a seemingly minor move may jumpstart massive deleveraging. This is what happened last fall in all credit markets, although Lehman’s bankruptcy was hardly a minor trigger event. But it certainly illustrates the point about the painful consequences of rapid deleveraging. A crowded trade will see many participants aiming to make the same move (selling assets to cover their short position) and it will have a whiplash effect on investors. What will force the current carry trade to unwind? First, the expectation that the dollar will begin to stabilize or rise will make shorting the currency less profitable and more risky. Another motivation right now might be year-end profit taking. Fund managers posted dismal results in 2008 and will be eager to lock-in better earnings before the end of 2009. Lastly, the expectation that interest rates will begin to rise. Higher rates drive borrowing costs higher and asset prices lower so the carry spread shrinks. As carry trade participants begin to unwind positions, bond investors should be weary. Large selling pressure will send bond prices down and yields up in a move that can happen quickly and dramatically. Investors should seek a defensive position by reallocating to short-term maturities and reducing overall bond exposure.