The mother of all carry trades
Marv Gandall
By Nouriel Roubini
Financial Times
November 1 2009
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.
The dollar and the sterling have weakened against a host of other currencies
since the summer, promoting speculation that they could become the next
carry trade currencies and supplant the yen as the ‘funding currency’ of
choice.
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 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.
People’s 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.
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. 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.
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. 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.
The writer is a professor at New York University’s Stern School of Business
and chairman of Roubini Global Economics
CEJ
Often the trading was out of Singapore, HK, Australia but
much of it goes back to London and NYC. Meanwhile, E. Asian savers
unknowingly financed this speculative bubble in commodities because
their
swavings and indirect bond investing linked to it was, at the next
level up, piling the money into London, NYC and Australia seeking
'better returns' than the low interest rates of the E. Asian
countries.
Now the focus is on dollar and pound borrowing but I would bet the
game is the same. And I would even bet it is E. Asian
and ME savers who ultimately are financing the bubbles. Even if it
amounts to the fact that their money is going into buying
US gov't bonds so the US can continue to keep interest rates at zero
(or even negative if you play the game well) and still
sell its trillion-dollar-deficit bonds.
Something has got to give in the US and the UK as far as interest
rates go, soon or later. But will anyone ever learn?
Why do they need a professor at NYU to tell them stuff like this? So
they can actually ignore it and get on with the next
bubble?
CJ