Roubini re USD Carry Trade – Back to the Future

Via an Edward Harrison post on Seeking Alpha, we learned of Nouriel Roubini’s recent comments that the USD is fueling the “mother of all carry trades” and creating multiple global asset bubbles.

Investors worldwide are borrowing dollars to buy assets including equities and commodities, fueling “huge” bubbles that may spark another financial crisis, said New York University professor Nouriel Roubini.“We have the mother of all carry trades,” Roubini, who predicted the banking crisis that spurred more than $1.6 trillion of asset writedowns and credit losses at financial companies worldwide since 2007, said via satellite to a conference in Cape Town, South Africa. “Everybody’s playing the same game and this game is becoming dangerous.”

The dollar has dropped 12 percent in the past year against a basket of six major currencies as the Federal Reserve, led by Chairman Ben S. Bernanke, cut interest rates to near zero in an effort to lift the U.S. economy out of its worst recession since the 1930s. Roubini said the dollar will eventually “bottom out” as the Fed raises borrowing costs and withdraws stimulus measures including purchases of government debt. That may force investors to reverse carry trades and “rush to the exit,” he said.

“The risk is that we are planting the seeds of the next financial crisis,” said Roubini, chairman of New York-based research and advisory service Roubini Global Economics. “This asset bubble is totally inconsistent with a weaker recovery of economic and financial fundamentals.”

There is plenty of truth in what Roubini said, but it’s nothing new — carry trades have been a recurring feature of the post-WWII global financial system, especially since the 1960s, when the breakdown of the Bretton Woods global gold exchange system began. And as we have noted for some time, the U.S. is in a long (perhaps multi-decade) cycle where monetary policies appropriate to domestic economic conditions will have inflationary consequences abroad, and thus some residual stagflationary effects at home. This is the inverse of the 1980s and 1990s, and parallels experiences of the 1960s and 1970s. And while we previously believed that fiscal, regulatory, and other economic policies were the only important drivers of such outcomes, we now believe that demographic trends play a major and possibly decisive role. If true, we expect with near certainty that current trends will remain intact through the next decade, based on global demographics. Economic policies certainly play a critical role, but their effects unfold at the margin, i.e., outcomes can be made marginally better or marginally worse by policymakers’ decisions (though history shows that there is always the possibility of policies going off the rails, and thus having more than just marginal effects).

Despite Roubini’s protestations, it’s not clear how far USD fueled asset speculation might go. Harrison rightly points out that Japan’s quantitative Yen easing in recent years coincided with bubbles in mortgage finance. But as we have pointed out in prior assessments of the crisis, that carry trade was amplified substantially by historic leverage ratios in the U.S. and parts of Europe among investment banks, some of their clients, and private households. This was due primarily to regulatory lifting of leverage limits and public support of mortgage markets, as well as bankruptcy reform legislation that made lending to consumers more attractive (or so it seemed at the time!).  That’s clearly not the trend at present: deleveraging continutes apace in the private sector, offset only partially by governments as they try to ameliorate declining resource utilization. Furthermore, some beneficiaries of the current carry trade are behaving rather soberly, at least for now. For example, Brazil recently instituted capital taxes to act as a brake on hot flows. That’s precisely the opposite of what homeowners, consumer credit borrowers, investment banks, private equity funds, hedge funds, and many others did during the height of the Yen trade.

Unfortunately, the global financial system is a rather efficient beast these days; not necessarily at finding the best targets and optimal levels of investment, but at finding and over-exploiting any pockets of demand for credit flows it can find, and at keeping sounder regulatory constraints at bay. And if a sounder regulatory framework and capital standards are not imposed globally – a risk that seems to have a rising probability at the moment – then Roubini will certainly be proven right, and our global financial system will impose substantial social costs on billions of people yet again. The more this song repeats itself, the worse the public’s demand for retribution will be on the other side of any future crisis. Bonus caps today, firing squads tomorrow?

URLs:

http://www.creditwritedowns.com/

http://seekingalpha.com/article/169364-is-u-s-dollar-carry-trade-replacing-the-one-in-japanese-yen?source=article_lb_articles

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=atlyygQuBLUI

http://symmetrycapital.net/idlespeculation/20090209.pdf