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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