# Block 026 — FX drivers / carry unwind regime

**Status:** ○ closed (Session 42, 2026-08-10). All 4 targets at Working+ across Sessions 40 (pre-read teach) + 41 (pre-block probes) + 42 (main material).
**Phase:** Phase 1 (FX — FX drivers framework, carry trade mechanics, carry unwind regime identification using BIS substrate from Block 025)

## Topic scope

Interest rate differentials, money supply, trade balances, liquidity, positioning. Carry trade mechanics. Carry unwind regime (2008, 2015 CHF, 2020). BIS-data-driven regime classification (Block 025 substrate applied).

## Plan

_(Filled at session close of prior block, per 2026-06-23 convention.)_

**Status:** ○ queued (assigned 2026-08-08, Session 39 close — Block 025 close).

**Pre-read (canonical source: `_session-state/2026-08-09-block-026-open-resume.md` `pre_reads` field — empty because substrate was taught inline Session 40):**

Pre-read list (historical reference for context; taught as substrate Session 40, no separate read required):

- **Hull 10e Ch. 6 (Interest Rate Futures) — currency futures section** (~15 min, [thematic]). For currency futures mechanics + basis as the difference between futures price and forward. Skip Hull's option-on-futures content.
- **Lyons "The Microstructure Approach to FX" — Ch. 1 (Overview) + Ch. 2 (The FX market: structure and evolution)** (~20 min, [thematic]). For the customer-dealer order flow framework (informational role of order flow, hot-potato inventory model, why carry trades persist despite convergence).
- **BIS Bulletins #90 (Aquilina et al., August 2024 yen carry unwind) + #124 (2025 state-dependent monetary policy transmission)** (~20 min, [thematic]). For the empirical carry-trade P&L decomposition, the August 2024 case study, and the carry-vs-vol regime substrate. Replaces the unverified Sarno/Schmeling 2014 reference (Session 40 verification: the current canonical BIS publications are Bulletins #90 + #124).

**Skip:**
- Detailed futures margin mechanics (covered in Phase 2 instrument dossier territory if reached)
- Hedge accounting for carry trades (Block 075 cross-asset territory)
- Carry trade tax treatment (jurisdiction-specific, not Block 026 substrate)
- Lyons Ch. 3+ (dealer behavior models — out of scope for Block 026)

**Pre-read compliance (2026-07-17 convention):** at session open, the user says "done" or "yes" and the mentor proceeds without per-source verification. Re-probe only triggered if the probe loop surfaces substrate as the failure cause. **Session 41 (2026-08-09): pre-reads taught as substrate per 2026-07-27 S32-side convention; pre-block probes fired 4/4 Working+ (Hull daily settlement / Lyons order flow / BIS #90 carry-vol regime / BIS #124 state-dependent transmission).**

**Delegation option (per 2026-07-27 S32-side convention):** if reading is too much, user can delegate pre-reads to side-session teach. Substrate → one mechanism cold-recall probe at a time → atomic Anki cards at end of each source.

**Total: ~55 min, [thematic].**

### Targets (provisional, refine at next session open per 2026-07-03 protocol):

- **Target 1 (likely):** FX drivers framework (interest rate differentials, money supply, trade balances, liquidity, positioning) + how each drives FX in normal regimes
- **Target 2 (likely):** Carry trade mechanics — direction, P&L decomposition (carry + spot + basis), funding cost vs carry, margin/leverage dynamics
- **Target 3 (likely):** Carry unwind regime — historical case studies (2008, 2015 CHF, March 2020) + the BIS-data-driven regime classification from Block 025 applied
- **Target 4 (likely):** PM implications — how to identify carry unwind regime before it happens, trade construction in carry unwind, interaction with cross-currency basis (Block 023) and CB reaction functions (Block 024)

**Carry-forwards from Block 025 into Block 026:**

1. **Carry trade direction (USER CORRECTION from Session 39):** borrow low-yield currency, invest in high-yield currency. Low EUR rates vs USD = MORE EUR/USD carry attractiveness, not less. This is the substrate that drives Block 026.
2. **BIS-regime-discrimination (Block 025 Target 4):** structural widening (FX swap share declining, demand rising via forwards/options, non-reporting bank share rising) vs transient dislocation (FX swap share stable, dealer BS normal, no forward surge). Will be applied to carry unwind regime identification.
3. **Fed-tool-trigger substrate (Block 025 Target 4):** Frame shift (leading) + cross-section break (coincident) + Fed action (lagging). Three signals for carry unwind regime shift identification.
4. **Layered dollar-funding architecture (Block 025 transition probe):** Fed swap lines (Tier 1) → dealer balance sheet (constrained) → non-bank intermediaries (marginal). Stress transmits bottom-up; Fed intervenes top-down. This is the substrate that explains WHY carry unwinds transmit stress so quickly.
5. **FX swap vs currency swap distinction (Block 025 vocab):** days vs years, liquidity tool vs financing tool. Important for carry trade funding leg identification.
6. **FX swap basis as diagnostic (Block 023):** basis level + sign + velocity + cross-section = balance-sheet tightness diagnostic. Carry trade funding leg = basis level, not spot rate.

**Teaching-module reference update:** Block 026 builds on Blocks 014 (carry unwind / global dollar funding read), 023 (CIP/basis), 024 (CB reaction functions), 025 (BIS regime classification). No new BIS reference updates needed for Block 026.

**Block 026 `## Plan` section to be filled at next session close (per 2026-06-23 convention).**

## Carry-forward to next block

Six substrate items carry from Block 026 into Block 027 (FX carry trades):

1. **Carry trade direction (locked).** Borrow low-yield, invest high-yield. Low EUR vs high USD = MORE EUR/USD carry, not less. (Session 39 user correction; reaffirmed in Target 2 Probe 4.)

2. **Carry = interface trade between rate-differential and vol regime.** Carry gains accumulate slowly in low vol regimes; losses come fast in vol regime shifts. "Nickels in front of a steamroller." (Target 2 Probe 4.)

3. **Three-layer alignment diagnostic.** Vol regime (low = carry reign), rate differential (wide = carry attractive), positioning (COT at extremes = crowded). Unwind triggers when vol regime shifts. Full alignment = crowding + persistent carry + low vol. (Target 4 Probe 1.)

4. **Carry unwind = positioning vs funding (BIS-regime-discrimination applied).** Aug 2024 = positioning (basis didn't reach crisis, no Fed action, days). 2008 / March 2020 = funding (Fed action, months/weeks). Cross-currency basis is the discriminator. (Target 3 Probes 1-2, Target 4 Probe 3.)

5. **Trade construction in carry unwind.** Pre-empt the unwind by going against the crowded carry. P&L = unwind move in FX, cost = negative carry drag. Time-to-resolution read determines sizing — fast unwind (positioning) = tight stops, short holding; slow unwind (funding) = wider stops, longer holding. (Target 4 Probe 2.)

6. **Carry P&L decomposition (carry + spot).** Per user clarification (Target 2 Probe 2): the basis is a SEPARATE diagnostic, not a P&L line. It matters most where there's explicit hedging demand (foreign investors hedging USD assets back to home currency). The carry trade is usually unhedged or implicitly hedged at the position level, not via FX forwards. (Target 2 Probes 2-3.)

**Anki cards pushed (4) — Block 026, Session 42:**
- 1786395139873 — Hull daily settlement reflexivity (Source 1, preread-source-1)
- 1786395139883 — Carry = interface trade (Source 3, preread-source-3)
- 1786395139891 — Aug 2024 signature (positioning not funding) (Source 3, preread-source-3)
- 1786395139900 — State-dependent monetary policy transmission (Source 3, preread-source-3)