Roubini - Mother of all carry trades

Has this been discussed yet? Interested in AF opinions. *********************************************************** Mother of all carry trades faces an inevitable bust By Nouriel Roubini Published: November 1 2009 18:44 | Last updated: November 1 2009 18:44 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. 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

Thanks for posting that. Good article. I think the dollar will remain weak for several months so hopefully these guys don’t get greedy and hold on too long.

Sweep the Leg Wrote: ------------------------------------------------------- > Thanks for posting that. Good article. > > I think the dollar will remain weak for several > months so hopefully these guys don’t get greedy > and hold on too long. I think the dollar should remain relatively weak for longer than a few months with all the money they are printing to buy treasuries and gse’s. The dollar is down approx 15% from March alone.

Just another economist explaining exactly why what he predicted yesterday didn’t happen.

NakedPuts Wrote: ------------------------------------------------------- > Just another economist explaining exactly why what > he predicted yesterday didn’t happen. This was my gut feel too. I was looking for some additional insights as to why I am wrong.

I think the key question is not so much whether past analyses predicted accurately, but whether the analyses (past and current) seem reasonable and well thought-out given the information available at the time. There are so many variables that go into economic and index performance, and the perception of those variables can change the variables themselves, that calling the shots correctly is not really the key to performing well. Rather it is to take reasonable educated guesses with appropriate risk controls. Where much expert analysis goes wrong is not necessarily the accuracy of the predictions - pretty much everyone performs poorly, but the overconfidence in the result that leads to overly concentrated positions and inadequate risk controls. You may call things right only 55% of the time, which is enough to do well, but if you think you call things right 80% of the time, you’ll end up losing.

mep_cfa’10 Wrote: ------------------------------------------------------- > Sweep the Leg Wrote: > -------------------------------------------------- > ----- > > Thanks for posting that. Good article. > > > > I think the dollar will remain weak for several > > months so hopefully these guys don’t get greedy > > and hold on too long. > > > I think the dollar should remain relatively weak > for longer than a few months with all the money > they are printing to buy treasuries and gse’s. The > dollar is down approx 15% from March alone. Timing it is going to be tricky. The dollar should be weak, but then I have to wonder what it will be weak against. Sure, commodity rich economies should see stronger currencies, but I don’t like the Euro or Yen much more than the dollar.

Is this actually true? “Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets…” Are there a significant number of investors shorting the USD to buy equities and other assets? Where does Roubini get his info? How does he know this is occuring?

He must be looking at the earnings of the big banks. The majority of their profits are in their trading division. Shorting could simply mean borrowing US dollars. At historical record low interest rates, why is it hard to believe that people are borrowing at close to 0% and buying all sorts of assets?

Let’s be real here, if he was so sure of all of these markets, he would not be an economist and would be managing money. He has admitted never owning a share of anything in his life. It’s all academic. And if he is such an economist, what is his solution to his predictions? Bottom line, those who can trade, trade. Those who can’t, don’t. Roubini is in the latter.

former trader Wrote: ------------------------------------------------------- > He must be looking at the earnings of the big > banks. The majority of their profits are in their > trading division. Shorting could simply mean > borrowing US dollars. At historical record low > interest rates, why is it hard to believe that > people are borrowing at close to 0% and buying all > sorts of assets? Who is borrowing at 0%? A couple of big banks sure, but who else? You certainly couldn’t borrow at 0%; I doubt anybody who walks off the street is going to get a $5 billion loan at 0% to invest in equities and commodities and whatever else. So a couple of big banks , lets say Goldman, JPM, BOA, Citi and a few others are all borrowing trillions of dollars at 0% and investing it in riskier high-yield assets? And this is driving a massive global asset bubble? If that’s the case, I call BS.

I agree with the professor and dont agree. Agree. Low fed rate combined with trillions spent by govt in QE programs are creating another asset bubble in domestic and foreign markets. Disagree. But did Fed have another choice? Earlier, they had to choose between creating this bubble or having deep Depression with complete meltdown of financial system. Given these choices, anyone would go for the former including professor himself. And Currently, the choice is between letting this bubble further inflate or have a double dip recession. Again, most will choose former. We know Fed is not attacking the roots, but we also know that attacking those roots is too costly at social, financial and political levels. We ultimately will have to pay its full price. But creating an option of paying it in installments is less difficult. Which is what Fed is trying to do. We as smarter investors should understand this bubble and should price our risks accordingly. So, when it ultimately bursts we dont get burnt with it.

He may be wrong. Who knows what the real potential GDP is in emerging markets and whether demand growth there will allow the fed and the ECB to slowly ween the economy off life support? And he may be right. Shorting dollars with the fed funds rate at 0 - 0.25% and the dollar tanking to fund long positions in anything creates some impressive leverage and this is probably creating a bubble. Roubini is not the first to suggest that there is an emerging markets bubble inflating. In any case there are plenty of funds / structured products which offer access to either play. But do yourself a favour and google this guy before writing him off as an academic hack who couldn’t get a “real” job. And as a trader?! Please…

newsuper Wrote: ------------------------------------------------------- > Is this actually true? > > “Investors who are shorting the US dollar to buy > on a highly leveraged basis higher-yielding assets > and other global assets…” > > Are there a significant number of investors > shorting the USD to buy equities and other assets? > Where does Roubini get his info? How does he know > this is occuring? Yes it’s very true, the carry trade is a very basic trade that is getting abused right now b/c of current and expected short term dollar weakness. It’s nothing new, (yen carry formerly, then yuan carry), the sheer volume now is what is the concern.

“they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised” what does negative 10 or 20% mean? how does he come up with that number? and why some traders’ borrowing cost is twice as much?

itstoohot Wrote: ------------------------------------------------------- > “they are borrowing at very negative interest > rates – as low as negative 10 or 20 per cent > annualised” > > what does negative 10 or 20% mean? how does he > come up with that number? and why some traders’ > borrowing cost is twice as much? I think he means they are borrowing dollars (which is in effect a short) and the dollar is falling- effectively leading to a negative interest rate. This is explained at the bottom of the 4th paragraph.

There’s actually a section on this in last year’s Level 2 curriculum…probably this year’s too but thankfully I don’t need to know. Anyway, you borrow (short) USD and buy an asset - say an emerging market bond. If the dollar weakens as it relates to the home currency of the bond you purchased then you not only get the yield on the bond but also benefit from the currency gain when you convert back to USD. If the dollar loses more value than your borrowing costs you get a negative interest rate.

Yeah. This is how I look at it. When you invest in a foreign asset you are essentially: 1 long the foreign asset 2 long the foreign currency (this automatically puts you short the domestic currency) The domestic currency falling is good for you since you are short. His point is once the dollar stabilizes the borrowing costs will be positive and if it starts to appreciate everybody will get crushed and be selling foreign currency to cover their dollar short.

mwvt9 Wrote: ------------------------------------------------------- > itstoohot Wrote: > -------------------------------------------------- > ----- > > “they are borrowing at very negative interest > > rates – as low as negative 10 or 20 per cent > > annualised” > > > > what does negative 10 or 20% mean? how does he > > come up with that number? and why some traders’ > > borrowing cost is twice as much? > > I think he means they are borrowing dollars (which > is in effect a short) and the dollar is falling- > effectively leading to a negative interest rate. > > This is explained at the bottom of the 4th > paragraph. thanks, didn’t have time to read the whole thing my bad. i think Roubini here is making a mistake as he treats positive foreign exchange returns as negative borrowing cost. his analysis is money but there’s problem with the wording.

Ok, I’m probably being simplistic, but I routinely hear comments to the effect of, “the modest recovery / stabilization alone does not justify the rebound in asset prices.” While these people are correct, this does not in and of itself mean we are in a bubble. Often enough we are completely ignoring the other portion of the risk - reward equation (or synonamously risk - growth from an equity valuation standpoint). While growth outlooks may not have improved much, I think you can make a strong case stating that perceived riskiness / variance in the markets has eased off considerably over the same period one year ago (when all he11 was breaking loose). Lower your risk premium even a modest amount and there you have the majority justification behind the market rally. That being said, I do think the long term growth assumptions in DCF models may still be over stated. Often the investing community is slow to depart from long standing traditional practices and are rarely willing to deviate long run growth expectations far from historic market and industry averages. A collective shift downward here could probably knock 10-15% off of market levels. I am in no way offering any predictions, just throwing this out there to see if you guys think I’m off base, etc.