Roubini: Mother of All Carry Trades Faces Inevitable Bust

3 posts / 0 new
Last post
DrKrbyLuv's picture
DrKrbyLuv
Status: Diamond Member (Offline)
Joined: Aug 10 2008
Posts: 1995
Roubini: Mother of All Carry Trades Faces Inevitable Bust

  (Complete Article Link)

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.

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 fundamentals.

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.

So 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.

While 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 terms.

The 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.

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.

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.

This 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.

 

Damnthematrix's picture
Damnthematrix
Status: Diamond Member (Offline)
Joined: Aug 10 2008
Posts: 3998
Re: Roubini: Mother of All Carry Trades Faces Inevitable ...

The rally in oil is not "a rally", that's how much it costs to produce oil post peak........  but of course you wouldn't expect an economist to understand this, not even Roubini!

Mike

Damnthematrix's picture
Damnthematrix
Status: Diamond Member (Offline)
Joined: Aug 10 2008
Posts: 3998
Re: Roubini: Mother of All Carry Trades Faces Inevitable ...

http://dharmajoint.blogspot.com/2009/11/roubini-forgets-riskiest-asset-of-all.html

Monday, November 02, 2009

Roubini Forgets the Riskiest Asset of All (the US$) 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 stableNouriel Roubini

Mr. Roubini, whose views I usually find most enlightening, was one of the few prominent economists who forecast the financial crisis of 2008.  Recently, however, perhaps due to a 2005 forecast of an unraveling of Bretton Woods II and sharp decline in the US$ that didn't pan out (at least so far), Mr. Roubini, judging by the above argument, assumes that the US$ is "here to stay" at least in the medium term. 

I disagree (and think he and Mr. Setser should have stuck to their earlier views- sometimes such things take time).

In A Brief History of Time, Stephen Hawking relates the story below which is quite germane to a discussion of Mr. Roubini's view.
A well-known scientist (some say it was Bertrand Russell) once gave a public lecture on astronomy. He described how the earth orbits around the sun and how the sun, in turn, orbits around the center of a vast collection of stars called our galaxy. At the end of the lecture, a little old lady at the back of the room got up and said: "What you have told us is rubbish. The world is really a flat plate supported on the back of a giant tortoise." The scientist gave a superior smile before replying, "What is the tortoise standing on?" "You're very clever, young man, very clever", said the old lady. "But it's turtles all the way down!"

The question, on what belief(s) does your argument rest, gained increased importance ever since David Hume pulled the rug out from under those who assumed any "real-world" arguments were validly based on pure reason. Hume's argument, never refuted, at least to my knowledge, is that "always being followed by" is not the same as caused by. We might infer such, and certainly act on the view that what has happened in the past will happen again, but as we didn't make the rules of the universe, we don't really know. At best we can believe.

On what turtle does Mr. Roubini's view rest? It rests on the view that the US$ has intrinsic value. As he argues: 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.

I ask, why can't the value of the US$ fall to zero? From the long view of History, the odds of a currency of virtually no intrinsic value declining to that value is high, which might explain Voltaire's quote on paper money.

Perhaps, however, Mr. Roubini was speaking of the medium term, and using the value of the Japanese Yen as a "turtle" to support his argument. Alas, the US is not Japan. Despite their fiscal woes, Japan runs a current account surplus- last month's surplus came in at $13B. The world is not awash in Yen, on the contrary, Japan is awash in US$s, as are quite a few other nations- China comes to mind.

When the Yen was the carry trade vehicle of choice, the risk, which manifested from time to time, was of a sharp rally due to the lack of Yen in international markets. If Japan ran a current account deficit this risk would be much diminished. I suspect if Japan was running a C/A deficit when it opted for a zero-interest-rate-policy (ZIRP) the Yen would have quickly lost a good deal of its value.

The US has both a C/A deficit and a ZIRP. While I agree with Mr. Roubini that the US ZIRP is inspiring the mother of all carry trades, which can inspire sharp corrections, that risk is, in my view, more than offset by the mother of all long positions in the riskiest "asset" of all, the US$. The ZIRP makes holding US$s a losing proposition, as Mr. Roubini notes.

The turtle on which Mr. Roubini's view stands is the notion that the US$ is an asset, when, in my view, it is a liability. By statute there is no fixed exchange rate between the US$ and anything other than US$ debts.  Each time an adjustment arises such that there is a shortage of US$s, the Fed rides in to "add liquidity" because they are more interested in keeping the big banks afloat than the currency. Until that changes, the mother of all carry trades will, despite the odd setback, continue to grow.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Login or Register to post comments