The roots of the coming crash

By Felix Salmon
November 4, 2009
Nouriel Roubini to burst my bubble. This isn't a case of the weak dollar making asset prices look good; in fact, it's the "mother of all carry trades", setting up "the biggest co-ordinated asset bust ever".

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I’ve had a vague sense of late that there’s a connection between the weak dollar, on the one hand, and rising asset prices, on the other. But I took some comfort in that: prices aren’t really going up as much as they look, it’s just that the dollar’s going down, so everything looks good in dollar terms.

Now, along comes Nouriel Roubini to burst my bubble. This isn’t a case of the weak dollar making asset prices look good; in fact, it’s the “mother of all carry trades”, setting up “the biggest co-ordinated asset bust ever”.

I believe him.

Nouriel’s analysis is quite compelling, given the way the carry trade works. In its most harmless form, people borrow at low rates in a funding currency and then invest the proceeds in a higher-yielding target currency. When that trade starts becoming crowded, the flow of money into the target currency causes that currency to rise, which makes the carry trade even more profitable — you not only pocket the spread between the two interest rates, but you also get a capital gain on the fx trade.

But this carry trade is even stronger still: not only are the target currencies rising, but the funding currency — the dollar — is falling. Players are making money on three different legs at once, and that means they can start investing not only in foreign currencies and local interest rates, but rather in a whole panoply of other asset classes, including commodities, energy, junk bonds, even equities. These assets might not yield much, but they don’t need to, if the funding currency is falling fast:

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.

And it’s actually worse still:

The perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight… By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets.

We’ve seen this movie before, in 2006, and I, for one, have no desire to relive it. A market where everything is rising is not an efficient market: it’s a market which is failing to do its job of allocating capital efficiently to where it can be put to best use, and away from areas where it can cause big problems. But no one cares about that these days — not even Nouriel’s own chief strategist, Arnab Das:

Emerging markets are poised to extend their biggest rally in a decade as investors borrow dollars to buy stocks, bonds and currencies in the world’s fastest growing economies, according to Arnab Das of Roubini Global Economics.

Investors should take “overweight” positions in developing-nation assets, said Das, the London-based head of market research and strategy at RGE, the research and advisory firm founded by economist Nouriel Roubini. While emerging markets will have “occasional corrections,” the surge in asset prices “has many legs to go,” Das said in an interview.

Das, here, isn’t contradicting his boss. (Although having worked at RGE myself, I know that Nouriel doesn’t mind at all when that happens, and indeed encourages a wide range of views within the organization.) Nouriel isn’t saying when the current bubble is going to burst — and if history is any guide, it’s probably going to be a long time before the inevitable happens. Of course, the longer that a bubble continues to inflate, the more painful the subsequent bust.

In that sense, every move upwards in US stocks or gold or the Aussie dollar or junk-bond indices is another step in exactly the wrong direction: it’s a step towards yet another massive crash. And it’s all being turbo-charged by Fed policy. If there’s a painless way out of this situation, I can’t see it.


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There goes Dr. Reality scaring the children again. Impressive stuff. I just want to know how he can knock out this kind of analysis during the day, and still have time to party til dawn with Oliver Stone? I heard this first this moringing on 1190 AM in DFW, where these two good ole boys seemed to agree wholeheartedly with Dr. Doom.

As I bonus, I learned that in Texas “Nouriel” is pronounced “Nurrel”.

This feels a lot like Japan’s interest rate policy for the past decade. Unless we act hard and fast in raising rates or getting assets of the Fed’s balance sheet, we could definitely get stuck in reverse.

his article is testable. he is not talking about a carry trade against a stable dollar (at any level) — he is talking about a carry trade against a dollar that is decreasing in value at a fairly rapid rate.

so his article implies that a crisis will occur when the dollar reaches a stable level.

Posted by q | Report as abusive

Roubini makes a valid point about the carry trade, but the big risk that he identifies is dependent on the dollar reversing its current slide. He doesn’t provide a realistic scenario for that to happen, other than an invasion of Iran, which, under the current administration, is unlikely. He also thinks an increase in US interest rates could trigger a stampede out of US equities, but anything more than a slight increase is unlikely in the next year or two. The economy is just not going to grow fast enough for the Fed to raise rates.

When you have a market that is so affected by the emotions of speculators, there is always the possibility that a sudden reversal can occur. Stock prices probably have risen too far too soon, but much of that is due to all of the liquidity that the government has been pouring into the economy – all you people who justify derivative instruments like CDSs and short selling because of their alleged contribution to liquidity can now see how this liquidity is being used – to speculate on equities and commodities, distorting their real values, instead of funding credit so that businesses can return to a normal operating environment.

The market will fall again, soon, once profits are captured, and speculators have identified some other way to make money. You know, like they could write analysts reports saying prices are too high, short stocks, and then buy them back after they fall.

re: “players are making money on three different legs at once”
When you sell a currency by definition you are buying another, so you can’t really say whether you are making money because one leg is going up or the other leg is going down: it’s all one trade. So you can make money on the interest rate differential and the change in exchange rates, but that’s only two legs total, not three.

Posted by YVRb | Report as abusive

I’ve read about this carry trade bubble elsewhere, but the question I haven’t seen addressed is:

Who’s gonna suffer most when the bubble eventually bursts? The developing countries where the assets are located or the US where the cheap money comes from?

Posted by EmilianoZ | Report as abusive

“The perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight… By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets.”

To me at least, this seems like a fairly profound insight. It explains what is happening now, as well as what happened before, when we supposedly diversified investors discovered that in a bubble regime, there are really only two classes of assets — cash and everything else. The implication seems to be that the dollar carry trade is ultimately a game of Old Maid. It’s sad that we have reached a point where feeding the carry trade is considered a legitimate use of the FED’s powers. Perhaps it has laways been this way.

Posted by maynardGkeynes | Report as abusive

A few issues and comments with this post: (1) Always enjoy Nouriel’s drive-by indiscriminate spraying of vitriol at recovering markets! (2) Rising stock markets in the EM are in no way due to any “mother of carry trades” at this point. Check out foreign inflows in all major EM. (3) Markets in those countries have been bought primarily through savings (internal and some external). One can argue that they have retraced back rather quickly. We shall see (4) The “massive liquidity” created by the Fed is primarily held by banks, at the Fed, earning interest and not dispatched to fund EM stock purchases. (5) As to why the Fed and other policy makers are doing this, you need to spend a little time; understanding an obvious need for the public sector to take up the baton of deficit, when the private sector is going through a gut wrenching de-leveraging is key. Short of this action, we would have been seeing the 1930′s movie and not the 2006 movie that the author is fearful of. Read Krugman’s many posts for god’s sake……

Posted by SDG | Report as abusive

David Goldman at Asia Times says that, to his knowledge, he is the first analyst to comment publicly on the negative dollar/equity correlation. Here he picks some bones with NR:

Posted by Mike | Report as abusive

This is nonsense. Carry-traders will just switch to the yen. There will always be a lowest-cost currency with plenty of liquidity.

Posted by VennData | Report as abusive

Felix, an interesting situation you bring up, especially when you combine this post with the post today from Michael Shedlock about the dollar in relation to certain precarious countries and regions.

A number of countries in Eastern Europe and also Japan are really on the precipice. If the wheels come off in one of these places, the dollar suddenly looks mighty nice.

The dollar collapse happened already, from 2001 to 2007 and it was a 50% haircut against some currencies and a 2/3 haircut against commodities.

Dear Ben, can I please borrow at 0% like Goldman Sachs? Just a mil or so, please? There are some foreclosures I want to buy and rent out. I promise it will stimulate the economy, which is just what the economy needs right now. Help me help you!

Posted by Dan | Report as abusive

I’m afraid that Dr Roubini is allowing his bearishness to get the better of him. When markets crashed last autumn, we heard a lot about how monetary policy would be impotent to stop this and how another Depression was inevitable. Now that looser monetary policy is working as it should, by pushing the dollar down and raising asset prices in expectation of improving fundamentals (ie no Depression), this is a bad thing. I agree that some assets look overvalued, but that is hardly a case of the Fed to tighten monetary policy. The US needs loose monetary policy and a weaker dollar. It’s up to the rest of the world to decide how best to deal with that.

Posted by Econoclast | Report as abusive

There is something unnatural to borrow from a country that is a net borrower itself. This kind of financial flow will have to be reversed sometime in the future. Where you may have had gradual build up of short dollar positions, once the trend is reversed even by a small amount, the dynamics of the system can change significantly. That is nobody likes to be the last person out, so the pure momentum of people rushing for the exit, first for locking their profits and later for cutting their losses, will lead to spectacular dollar comeback.

Shnaps: – this was obliviously written with a huge hamgover.

Well said Dimitar, let them carry on with the Dollar-bashing.

Posted by Depeche Mode | Report as abusive

Actually it is the right direction. Real interest rates have fallen and will continue to fall so assets should be higher valued. Only when there is real growth to attract funds will the rise in assets be suppressed, but that will provide real investment opportunities. Until that occurs, all assets should rise.

Posted by Lord | Report as abusive

This is the problem with you bearish clowns. You have no clue whatsoever about when the thesis will unfold.

Nouriel isn’t saying when the current bubble is going to burst — and if history is any guide, it’s probably going to be a long time before the inevitable happens. Of course, the longer that a bubble continues to inflate, the more painful the subsequent bust.

This “analysis” is NOT useful to anyone.

Posted by Charles Jones | Report as abusive

This “analysis” is meant to scare you, Charles.

Roubini’s entire scripted existence is a mechanism to scare you.

First they used our greed, and now they’re using our fear. The big question is, who are “they.”?

I’ll take Dr Roubini’s advice. He’s got that rarest of combinations: respect and credibility.

Posted by kthomas | Report as abusive

Uncle Billy, let’s recall Marilyn Manson’s comment in Bowling for Columbine. Fear drives everything. In my opinion it is the constant bombardment of movies and advertising, materialism and of course religious pressure of a moral hazard nature. From experience, I would say 50%+ of the World Press attract readers with this magnet of fear.

Posted by Depeche Mode | Report as abusive

From the article: “Nouriel isn’t saying when the current bubble is going to burst — and if history is any guide, it’s probably going to be a long time before the inevitable happens. Of course, the longer that a bubble continues to inflate, the more painful the subsequent bust.”

I have to disagree that a coming “bubble burst” is far away. There are many signs of danger in the markets right now. I have written of many of them at this link to my blog: 1/02/danger-in-the-markets-part-i/

and of course when it all hits the fan, the usual suspects will repeat their endless mantra of how “free market casinos are the scurge of mankind”.

Posted by yo | Report as abusive

Maybe an old idea will transform current abstraction into a grounded reality. Local economic development. Banks grounded in local and regional business and manufacturing. Manufacturing and farming based on local and regional distribution. Once local and regional needs are met, only then does export further afield become an option. Maybe even the development of local and regional stock markets bear examining. see

Getting people excited and participating in this type of world is the only problem.

The USD will rally.

My long term USD indicator has been giving BULLISH warnings for a while.

I use technical analysis to identify trends.

My indicators can identify trend changes before they occur.

They warned me of an impending market crash back in early *2007*

The VIX continues to give bullish warnings as well.

The primary trend for stocks remains down, is the current bear market rally ending ?