I’ve mentioned the “carry trade” relating to US dollar weakness and equity and other asset bubbles worldwide, but I would expect that few readers understood what I was referring to. I understand it conceptually, but, like short-selling, futures and options trades and combinations, and so on, until you actually do them or see them done, such transactions can remain hard to grasp.
An op-ed written by Nouriel Roubini – who was widely recognized as a Cassandra of ’08 doom, then, naturally, put back out of public mind – for yesterday’s Financial Times explains the carry trade succinctly, and also summarizes its implications.
Here are a couple of useful excerpts – first on the global multi-bubble:
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.
On the policy dilemma and on the virtually inevitable resolution:
[I]f 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.
Reading the whole thing will require a (free) FT registration if you don’t already have one. It will be well worth the hassle if you’re interested in understanding the underlying mechanisms and larger dimensions of the financial trouble we seem to be making for ourselves.
