The article below is an excerpt from our Q3 2025 commentary.
In our fourth-quarter 2024 letter (click here to view past commentaries), we introduced a framework that has since shaped much of our thinking about commodity cycles—the “Carry Bubble.” Drawing heavily on The Rise of Carry by Lee, Lee, and Coldiron, we argued that the four major commodity cycles of the last 125 years fit neatly within a broader and more predictable carry cycle. It is worth returning to that idea now, and examining how such a regime ultimately ends and what may greet investors once it does.
The authors describe with careful precision the mechanisms that produce and extend a carry regime. The standard example involves borrowing in a chronically low-yielding currency, such as the yen, and investing in a higher-yielding asset, often in Australia. Provided exchange rates remain calm, the trader simply earns the spread between borrowing costs and asset returns.
Lee, Lee, and Coldiron argue that this is only one instance of a much larger class of trades. What they share is straightforward: each relies on leverage, and each depends on a world that does not change too abruptly. They are, in effect, short-volatility trades that do well when conditions stay steady.
In theory, such trades should not survive. Arbitrage should eliminate any persistent yield difference, either by pushing up asset prices or shifting exchange or funding rates. Yet the historical record shows that carry trades not only exist, but often produce durable positive expected returns.
The authors note that this outcome is not as puzzling as it seems. Carry trades often offer small, steady gains until they meet the kind of volatility that wipes out years of prior profits. The returns simply compensate the holder for that eventual risk. It is the quintessential picking up of pennies in front of the proverbial steamroller.
Once you recognize that nearly all levered short-volatility trades are simply carry trades in another form, it becomes easier to see how the “Rise of Carry” has come to shape almost every corner of modern markets. Private equity and private debt, for example, operate as large-scale carry trades: they rely on cheap bank financing to amplify the modest spread between borrowing costs and asset returns. As long as conditions remain stable, the PE investor is virtually assured a positive long-term result. Hedge funds function as “agents of carry” as well—using leverage to enhance returns and collecting fees on gains without having to repay losses. If tomorrow resembles today, as it often does, they earn substantial incentive fees; when volatility finally catches up with them, they simply return capital and start over. Even the S&P 500 now exhibits carry-like behavior, as executives—motivated by compensation tied to share prices—capitalize on the spread between low-cost debt and corporate returns by aggressively buying back their own stock.
Carry regimes come with several important quirks. To begin with, they are momentum-driven feedback loops rather than mean-reverting systems. When trillions of dollars chase levered short-volatility trades, both implied and realized volatility are pushed lower—just as a flood of money into a long-Tesla position inevitably drives the stock higher. Carry trades depend on the premise that what has worked will continue to work, which is essentially what low volatility represents. As a result, winners are carried upward: large companies grow larger, growth stocks surge, and value investing is pushed to the sidelines. Value requires the future to diverge from the present—an asset must be mispriced today and eventually be recognized as such. In a carry regime, that recognition rarely comes. Thus growth outperforms value, and large caps beat small caps. Because these regimes thrive in environments of low rates and low volatility, investors naturally assign high values to far-off cash flows and feel comfortable extrapolating strong earnings growth well into the future. Those distant cash flows, in turn, are discounted at low real rates, reinforcing the effect.
Despite their persistence, carry regimes are not the natural state of financial markets. Over long stretches of history, value has consistently outperformed growth and small-cap stocks have outperformed large caps. But those fundamental patterns are often suspended during extended carry regimes. Another notable feature is how much capital these regimes absorb once momentum takes hold. As money pours in, financial assets are pushed far above levels justified by the underlying economy. Whereas financial assets have historically averaged around 75% of GDP, during carry bubbles they can climb to well over 200% of GDP— much as we see today.
During these periods, real assets tend to hold very little appeal for most investors. Why bother with a finite, delineated resource when volatility is low, interest rates are benign, and the market offers a Hyper Scaler that promises to remake the world? As a result, natural resource equities typically struggle in major carry regimes. At best, investors ignore them; at worst, they become part of the short book used to reduce net exposure and make room for more leveraged long positions in winning carry trades. Looking back, we found that every major commodity bear market coincided with a carry bubble. In that sense, this cycle is no exception.
Why own natural resource equities at all? The answer is straightforward: carry regimes are inherently unstable. They persist only as long as conditions allow, and then they unwind abruptly. That was the pattern in 1929, in the 1970s, and again in 1999—and it will be the pattern in this cycle as well.
This naturally raises the question: what brings a carry bubble to an end, and what does the market look like afterward? In almost every instance, the catalyst is a major shift in the monetary regime—something large enough to reset the system and restore balance.
Put simply, a carry regime thrives when tomorrow looks like today; it ends when tomorrow looks markedly different. With so much capital tied to levered short-volatility positions, a meaningful rise in volatility is usually enough to trigger a broad unwind. These are, in effect, two ways of describing the same phenomenon. At the center of it all are the Central Banks.
To see why, it helps to recognize that Central Banks are the primary enablers of carry. In theory, the returns from a carry trade compensate the investor for the risk of a sudden break in the status quo—a spike in volatility, or in equity markets, a crash. But in recent decades, Central Banks have repeatedly stepped in to prevent those breaks. The 1990s saw the “Greenspan put”; the Global Financial Crisis brought “Helicopter Ben”; and COVID led to the United States’ first near-direct monetization, with stimulus checks mailed to millions of households. When policymakers reliably cushion markets from catastrophic loss, the incentive to push carry trades for years becomes entirely rational.
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