Roubini Calls the Next One

You've probably heard of Nouriel Roubini. He's one of the handful of economists and financial analysts who back in the earlier half of the oughts tried to warn everyone that the real-estate boom was due for a catastrophic bust. Needless to say, after half a decade of being cast as Chicken Little, he has since 2007 received much belated and deserved attention in the press.

And for all that attention, he may very well be the Nostradamus with a calculator that so many make him out to be. Or maybe, on the other hand, he's just a broken clock with a particularly bearish bent and the good fortune of living through the economic apocalypse he has always predicted. I have no way of judging.

What I do know is that, whether you trust him or not, he is probably worth hearing out. Especially when he starts making predictions like this:

Mother of all carry trades faces an inevitable bust

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 fueling 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. (FT)

To summarize, there are two separate but intimately related factors at work. On the one hand, the Fed has pushed interest rates down to near-zero. Which is to say that, at least for institutional investors, it is almost free to borrow in or from the U.S.. If you happen to be a interested in investing your money in Australia or Japan or Britain, it likely makes more sense to borrow in the U.S. and trade those greenbacks in for Australian dollars or Yen or Pounds, rather than borrowing in the country of investment itself at a higher rate.

The second factor is the general poor performance of the U.S. dollar. As the U.S. dollar continues to decline versus most major currencies, the money an investor borrows in the U.S. in October will be worth less relative to other currencies when it comes time for that investor to pay up in November. For example, let's say you borrow $1000 in the U.S. at 1%, exchange those dollars for $1100 Canadian at a rate of 1.10 to 1 U.S. dollar, and invest in some Canadian asset at 3%. If the exchange rate remained stable at 1.10, your C$1100 investment has matured to C$1133 (1100 x 1.03), which you can exchange back for US$1030. Since you owe $1010 on your 1% loan, your profit from the deal is $1030 - $1010 = $20, or 2%, exactly the difference between the Canadian interest rate (3%) and the American rate (1%).

But if the U.S. dollar depreciates (i.e. becomes worth less versus the Canadian dollar)--let's say the dollar sinks from from 1.10 to parity, 1:1, over the period of maturity of your investment--your C$1133 investment return in Canada is all of a sudden worth $1133 in the U.S.. Subtracting the $1010 you owe on your loan, you come away with a handsome $123 return (12.3% = (1.03 x 1.10) - 1.01) instead of $20. As an investor, as long as you get at least 91.81% of your principal back, you still come out on top. In other words, the further the U.S. dollar declines, the more risky you can afford to be with your international investment.

On a grander scale, since the U.S. dollar has been declining against virtually every other major currency, says Roubini, the dollar has in this way become the "funding currency" for risky investments across the globe. This, he argues, is further exacerbated by the Fed's policy of quantitative easing, in which the Fed has been pushing down interest rates not only on short-term Treasury bills, as is traditional monetary practice, but on longer term Treasury securities, agency securities, and even mortgage-backed and corporate bonds. By decreasing the spread between "safe" assets, like U.S. government debt, and the more risky assets listed above, the Fed is inadvertently stoking a sense of artificial confidence in the market while driving investors towards ever riskier, higher yielding assets.

According to Rouini, there are only a few ways this can end:

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.

In other words, this will end if a) the dollar stops declining, which he sees as inevitable b) the Fed stops propping up riskier assets, which he also sees as inevitable, or c) the U.S. economy either improves or declines. Nice odds.

The most important point here is that as he sees things, once things start to unravel, they are doomed to unravel quickly and with self-perpetuating destructive force.

[I]f factors lead the dollar to reverse and suddenly appreciate...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.

Any appreciation or expected appreciation in the dollar will lead investors to pay back their dollar positions quickly, which, he argues, will lead to a further appreciation of the dollar. And because the dollar happens to be the safe-haven currency to the world, panic will beget panic.

How afraid should we be? Not knowing much about it, I would say that unless the vast bulk of the carry traders are financing absolute junk, I don't see why a gradual stabilization of the dollar can't lead to an equally gradual evaporation of the carry trade as investors close their positions, not necessarily at a loss, but at less of a gain than one might otherwise anticipate. That being said, if the dollars starts rapidly climbing for any particular reason, we are likely as fucked as he says we are.

Either way, no matter how much credence you put into this particular analysis, I suppose we can all consider ourselves warned.