Latest from Roubini

this is a scary article. Interest rates at near zero, and we are getting some strange effects that will effect us all….

in reference to:

“Mother of all Carry Trades Faces an Inevitable Bust


Nouriel Roubini
Nov 1, 2009

From the FT:
Since March there has
been a massive rally in all sorts of risky assets – equities, oil,
energy and commodity prices – a narrowing of high-yield and high-grade
credit spreads, and an even bigger rally in emerging market asset
classes (their stocks, bonds and currencies). At the same time, the
dollar has weakened sharply, while government bond yields have gently
increased but stayed low and stable.
This recovery in risky
assets is in part driven by better economic fundamentals. We avoided a
near depression and financial sector meltdown with a massive monetary,
fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped,
as consensus believes, or U-shaped and anaemic as I have argued, asset
prices should be moving gradually higher.
But while the US and global economy have begun a modest
recovery, asset prices have gone through the roof since March in a
major and synchronised rally. While asset prices were falling sharply
in 2008, when the dollar was rallying, they have recovered sharply
since March while the dollar is tanking. Risky asset prices have risen
too much, too soon and too fast compared with macroeconomic
So what is behind this massive
rally? Certainly it has been helped by a wave of liquidity from
near-zero interest rates and quantitative easing. But a more important
factor fuelling this asset bubble is the weakness of the US dollar,
driven by the mother of all carry trades. The US dollar has become the
major funding currency of carry trades as the Fed has kept interest
rates on hold and is expected to do so for a long time. Investors who
are shorting the US dollar to buy on a highly leveraged basis
higher-yielding assets and other global assets are not just borrowing
at zero interest rates in dollar terms; they are borrowing at very
negative interest rates – as low as negative 10 or 20 per cent
annualised – as the fall in the US dollar leads to massive capital
gains on short dollar positions.
Let us sum up: traders are
borrowing at negative 20 per cent rates to invest on a highly leveraged
basis on a mass of risky global assets that are rising in price due to
excess liquidity and a massive carry trade. Every investor who plays
this risky game looks like a genius – even if they are just riding a
huge bubble financed by a large negative cost of borrowing – as the
total returns have been in the 50-70 per cent range since March.
sense of the value at risk (VAR) of their aggregate portfolios ought,
instead, to have been increasing due to a rising correlation of the
risks between different asset classes, all of which are driven by this
common monetary policy and the carry trade. In effect, it has become
one big common trade – you short the dollar to buy any global risky assets.
Yet, at the same time, the perceived riskiness of individual
asset classes is declining as volatility is diminished due to the Fed’s
policy of buying everything in sight – witness its proposed $1,800bn
(£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed
securities (bonds guaranteed by a government-sponsored enterprise such
as Fannie Mae) and agency debt. By effectively reducing the volatility
of individual asset classes, making them behave the same way, there is
now little diversification across markets – the VAR again looks low.
the combined effect of the Fed policy of a zero Fed funds rate,
quantitative easing and massive purchase of long-term debt instruments
is seemingly making the world safe – for now – for the mother of all
carry trades and mother of all highly leveraged global asset bubbles.
this policy feeds the global asset bubble it is also feeding a new US
asset bubble. Easy money, quantitative easing, credit easing and
massive inflows of capital into the US via an accumulation of forex
reserves by foreign central banks makes US fiscal deficits easier to
fund and feeds the US equity and credit bubble. Finally, a weak dollar
is good for US equities as it may lead to higher growth and makes the
foreign currency profits of US corporations abroad greater in dollar
reckless US policy that is feeding these carry trades is forcing other
countries to follow its easy monetary policy. Near-zero policy rates
and quantitative easing were already in place in the UK, eurozone,
Japan, Sweden and other advanced economies, but the dollar weakness is
making this global monetary easing worse. Central banks in Asia and
Latin America are worried about dollar weakness and are aggressively
intervening to stop excessive currency appreciation. This is keeping
short-term rates lower than is desirable. Central banks may also be
forced to lower interest rates through domestic open market operations.
Some central banks, concerned about the hot money driving up their
currencies, as in Brazil, are imposing controls on capital inflows.
Either way, the carry trade bubble will get worse: if there is no forex
intervention and foreign currencies appreciate, the negative borrowing
cost of the carry trade becomes more negative. If intervention or open
market operations control currency appreciation, the ensuing domestic
monetary easing feeds an asset bubble in these economies. So the
perfectly correlated bubble across all global asset classes gets bigger
by the day.
But one day this bubble will burst, leading to the
biggest co-ordinated asset bust ever: if factors lead the dollar to
reverse and suddenly appreciate – as was seen in previous reversals,
such as the yen-funded carry trade – the leveraged carry trade will
have to be suddenly closed as investors cover their dollar shorts. A
stampede will occur as closing long leveraged risky asset positions
across all asset classes funded by dollar shorts triggers a
co-ordinated collapse of all those risky assets – equities,
commodities, emerging market asset classes and credit instruments.
Why will these carry trades unravel? First, the dollar cannot
fall to zero and at some point it will stabilise; when that happens the
cost of borrowing in dollars will suddenly become zero, rather than
highly negative, and the riskiness of a reversal of dollar movements
would induce many to cover their shorts. Second, the Fed cannot
suppress volatility forever – its $1,800bn purchase plan will be over
by next spring. Third, if US growth surprises on the upside in the
third and fourth quarters, markets may start to expect a Fed tightening
to come sooner, not later. Fourth, there could be a flight from risk
prompted by fear of a double dip recession or geopolitical risks, such
as a military confrontation between the US/Israel and Iran. As in 2008,
when such a rise in risk aversion was associated with a sharp
appreciation of the dollar, as investors sought the safety of US
Treasuries, this renewed risk aversion would trigger a dollar rally at
a time when huge short dollar positions will have to be closed.
unraveling may not occur for a while, as easy money and excessive
global liquidity can push asset prices higher for a while. But the
longer and bigger the carry trades and the larger the asset bubble, the
bigger will be the ensuing asset bubble crash. The Fed and other
policymakers seem unaware of the monster bubble they are creating. The
longer they remain blind, the harder the markets will fall.”
RGE – Mother of all Carry Trades Faces an Inevitable Bust (view on Google Sidewiki)

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