Zero Cost Carries

Interest rates as a pricing mechanism in the economy go much deeper than the superficial assessments of mortgage loan rates or what one earns on deposit. Arguably one of the most significant jobs of interest rates as a pricing mechanism is the “cost of carry”.

This in plain language means how much it would cost to buy any item for resale at a future date. A simplified example may help. Say a store buys a product for resale at $100 with the aim of selling it within one month. Now let us state that interests rates at that time was 12%. That would translate into an interest rate of 1% for one month. So the store owner would have a cost of carry of $1.

The store owner paid $1 to carry the stock for one month. Say in this example that the store owner would have expected to make a net profit of $10 on the sale before paying for the cost of carry. That would imply that the store owner’s cost of carry would have calculated as 10% of the net profit. The importance of cost of carry is yet but partially explained.

What happens should the product not sell as expected in one month and the store owner is only able to achieve the sale after 12 months? Cost of carry now amounts to $12 and has wiped out the entire expected net profit and some. Accountants developed a measure to manage cost of carry in a stock turnover ratio. The manager would ensure that the total stock turns over as fast as possible to keep cost of carry as low as possible. The store owner would be encouraged to purge slow moving unwanted stocks from inventory through the cost of carry mechanism. A desirable and economically efficient behaviour trait operating on autopilot without outside intervention.

The principles of cost of carry translate directly into financial markets and financial speculation. Interest rates are not the only component in cost of carry but have always been an important component, that is before the advent of the zero bound interest rate policies of central banks.

Say you want to speculate on a rising oil price. Calculating the cost of carry on your position follows this economic and accounting logic. You borrow the cash required to make the purchase. Buy the oil and store it. Cost of carry will be the interest paid on the loan and the cost of storage for the period from when you entered into the transaction until you chose to exit. That’s the basics. Why should it be significant?

Cost of carry cascades through the economic fabric in millions of ways. A real estate owner for profit would purchase a commercial or industrial property and the expected profit would be the rental incomes, less cost of carry, less operating expenses. A speculator in shares would expect a profit equal to the difference between the buying and selling prices, plus dividends, less cost of carry. Interfere with this mechanism and it impacts as wide as supply and demand variables of property. Too low interest rate and access to easy credit would drive up demand and prices in no time for example. That is the birthplace of property bubbles (and all other asset inflations also known as asset bubbles).

The whole economic cosmos of derivatives is priced on a cost of carry basis. Forward cover on foreign exchange (say $/Yen) is based on the perfect hedge of borrowing the dollars and purchasing yen at inception. Invest the yen for the period. Cost of carry for the period would be the dollar loan cost less the yen income, both interest rate denominated. Thus the forward price of Yen would be the spot (today’s price) plus the cost of carry, which may be positive or negative. A neat little cross border trick performed by interest rates in this pricing mechanism. Mess with the interest rates in one or both sovereign economies and the exchange rate pricing mechanism get similarly messed up.

Interest rates are an invisible spider’s web influencing every price of every type of good or service produced in the economy. No matter where you touch it, it reverberates throughout the whole structure. Interest rates would regulate the allocation of scarce savings, and yes savings are always scarce without huge quantities of debt facilitating liquidity provision from the central banks. This job of allocation by interest rates when interest rates are free form manipulation or outright control is performed as a delicate harmonious melody throughout the economy in that invisible spider’s web. The dynamic takes cognisance of economic merit right down to the smallest individual transaction maintaining an intricate economic balance which in turn contributes to the harmony of all other pricing mechanisms.

Just try and imagine the corps of central bankers required to perform the same functions previously performed by interest rates without the interfering central bankers. It is not only probable but guaranteed that these delicate operations will no longer take place. At first the interest rates just gets distorted. The distortion in interest rates distorts all other pricing mechanisms and influences the choices and behaviour of economic participants. The previous dynamic harmony is lost.

Sadly it does not stop there. Every intervention breeds another intervention to sustain the distortion of the previous intervention. All interventions breed like germs on rotting flesh left outside in the sun and spread like a virus on a university open website. The interventions accumulate and compound and monetary policy interventions reach the pinnacle of absurdity when it attains that final resting place of the zero bound.

The central bank has effectively discontinued the base interest rate from the economic landscape. Of the spider’s web which were tattered and torn by interventions now only remains a few malfunctioning strands. Interconnecting harmony and relative rebalancing is but an abstract memory.

Then again why would it matter? Unfortunately it matters very much. Visualise an economic pickup truck with no intricate wiring. Nothing works and it is simply being pushed around by government and central bank officials. Having destroyed the fabric of pricing mechanisms are not without consequences. Those consequences are as varied and as complex to pin down as were the contribution of interest rates to the pricing mechanisms.

Cost of carry is but one component where consequences will manifest. Staying with the examples given we can see that inventory management has been compromised and dead stocks can be carried without cost, which will certainly diminish efficient management of stock levels; the oil speculator can double or triple his position and carry it for longer with an immediate consequence that the price of oil may rise for everyone else though the general tendency would be for oil prices to become unstable and subject to violent unpredictable adjustments; the most obvious consequence for real estate is similarly boom bust pricing cycles but a menacing economic rot in the encouragement to banks to roll and refinance bad debs while in reality becoming owners of the properties on a zero interest cost of carry is a less obvious outcome; perhaps the most devastation to pricing mechanisms are the consequences of a zero cost of carry on derivative markets distorting macro pricing of exchange rates between currencies, hedging and arbitrage in all commodities and financial securities across all forms of derivatives from the plain futures and options to the exotics. No pricing mechanism is spared the taint.

A very real example which carries influences from cost of carry on inventory, to finance, to derivatives and even sovereign currency pricing is copper. Thus we can observe the absurdity of huge stockpiling and rising prices concurrently in real time.








The global economy is now cursed with the affliction of the zero bound interest rate policy in all the major economies. Thus all micro and macro pricing mechanisms must function with the heavy hand of central bank bureaucrats allocating with bias, subject to vested interests and central government direction. They only allocate where they can see and how they desire in the absence of the delicate spider’s web of dynamic interest rate allocation on economic merit.

Adam Smith’s invisible hand of the market has been chopped off at the elbow.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
31 January 2010


© Sarel Oberholster



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Twin Peaks – Jumping in Mud

In this edition of Twin Peaks we continue to monitor the unfolding developments in the Global Financial Crises (yes it is still with us) and the developments of the post Dec 1989 crises in Japan as expressed in the Dow and the Nikkei. The thesis as has been discussed at length in previous Twin Peaks series, is that the USA and Japan are following similar monetary policies of excessive monetary stimulation which achieved an artificial market condition described as “the zero bound” where short term interest rates are stuck at zero or near zero for extended periods. The 1989 economic collapse in Japan initiated its drive towards the zero bound and the USA started its march towards the zero bound after the 2007 economic crises. Both economies have achieved the condition of being stuck in the zero bound but the USA is about 18 years behind Japan. The zero bound monetary policy combines with Quantitative Easing and fiscal policies of budget deficits to generate an explosion of public debt.

The present tale of the charts is one of divergence. The USA chose aggressive monetary and fiscal interventions while the Japanese took a more measured approach. It is the Bernanke theory that this difference is what will distinguish the USA from Japan, where the USA will recover to rapid economic growth as opposed to the Japanese experience of a low level deflationary depression stretching over two decades and entering its 3rd.

The aggressive policies of the USA are showing up in the charts. That does not mean that the Bernanke theory is proven, it simply means that the markets reacted in predictable fashion to the very aggressive government policies. Government and central bank interventions are not self sustaining and must be repeated in ever growing tranches to simply maintain a stimulation effect. The next stimulation will need to be even greater than the previous two but it may not be as visible due to the adverse political consequences attached to the previous spectacles.

Stimulation decay sets in after a while unless, and this is what is hoped for, the spark provided by the government is sufficient to get the economy going. The jury is out on whether stimulation will be a gasoline and newspaper bonfire burning fast and bright for a while to sputter and die or not. Everything rides on that outcome.




(Click chart to enlarge.)

The peaks of the Nikkei and the Dow are matched in this chart and not rebalanced thereafter to allow for significant deviances. The peak of the 1929 Dow has been added just to spice up the test against depressionary conditions. The aggressive US intervention has now carried the Dow upwards beyond the levels of the Nikkei, for a similar period as unfolded. The positive divergence in itself is not compelling as the initial equally aggressive reactions to the 2007 crash caused a similar positive divergence then, which was resolved with a dramatic convergence and negative divergence between October 2007 and April 09. This chart does not show it but the long term bottom of the Nikkei since Dec 1989 is as recent as 10 March 2009 at 7054.98.

The decay in the stimulations is already showing up in the momentum inherent to the move from April 2009.

The Momentum chart hereunder needs some explanation in interpretation. It measures the relative change in the gap between the 50 day moving average and the 200 day moving average, counting backwards. A 180 degree flip-over (negative to positive) in data occurs when the 50 dma crosses over the 200 dma.

Here’s what the chart tells us. The momentum in the bear move down was failing for weeks before late March, early April 2009. The bear market momentum gave way to a negative momentum bear, i.e. a bull market momentum since early April 2009. The flip-over/crossover occurred just before the end of June 2009. Momentum still spiked unto mid July but since then bull momentum has been in decline. The “jumping in mud” period started in late October 2009 where the market is still in bullish trend but just can’t get going.

Presently we are still in the “jumping in mud” phase but the beginning of a downward trend is showing up in the negative momentum bull, i.e. the bull marked momentum is failing. We have not yet reached a point where we can make a call to say that the bull marked has failed. The historic indications are that a -1.5% to a -2% recording is required to indicate a high probability that a bear market move is underway. The highest recording was -0.7% on Dec 31st 2009. So for now it is simply “jumping in mud” time until momentum picks up in either direction.




(Click chart to enlarge.)

The here and now is where the bulls will believe in the Bernanke thesis that this time it will be different for we acted faster and with more aggression in our stimulations. The bears will continue to claim that the speed and extent of intervention will not alter the outcome of a deflationary depression only how we get there. They would further insist that the likely outcome of a too fast and too furious monetary response will harvest an even worse outcome of a hyperinflationary depression in an effort to escape the deflationary depression. Already gold, silver, copper and every other commodity are being stuffed in custody and warehouses discounting such excess. Another vote of no confidence in official policies and not a sign of economic recovery.

The Japanese economy in this phase was typified by warehousing growing bad and delinquent debt with central bank and central government support. Mortgage debt for instance was warehoused in the Jusen structures, with similarities to the Freddie Mac and Fannie Mae structures in the USA. Every stimulation, regulation and intervention was aimed at reviving the asset inflation pre 1989 and denying the accumulation of decay in the economy. The economic events forced Japan to disprove the Keynesian theories of sticky downwards salaries and wages when after endemic unemployment, salaries and wages stated falling. Asset inflations never revived and in fact continued to deflate as each stimulation and intervention to prevent that outcome failed. Minuscule rises in interest rates or in direct or indirect taxes dumped the economy right back into crash mode, stumbling through two decades of economic decline until government debt equalled national savings in this previously high net savings nation.

Perhaps this time the outcome of Zero Bound and Quantitative Easing monetary policies combined with budget deficits and excessive government debt will be different, but probably not.

May you trade with wisdom and reward in 2010.


Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
6 January 2010

Ps. I will post a news flash update should the Momentum chart post a negative 1.5%.


© Sarel Oberholster


Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .