Masters of the Universe: They’re baaaack…

A new BIS paper has some very telling data points. First, they demonstrate the extent to which leveraged financial speculation drove foreign currency movements in the financial crisis (it’s quite reasonable to assume that this factor was at work in other asset class dislocations too). Second, it provides evidence that highly leveraged masters of the universe were back to their old tricks in fairly short order.

Let’s start with a  quick primer on “carry trades.”  A carry trade occurs when a financial market participant borrows in some currency with a low nominal interest rate (the “funding currency”) and invests the loan proceeds in some asset(s) (a “target asset”) that’s expected to appreciate at a rate that exceeds the interest rate due on the borrowed currency. The target asset can be a higher yielding currency, a credit instrument, equities or a stock market proxy, commodities or a commodity index proxy, and so on.

The Yen carry trade — borrowing low yielding Japanese Yen and using them to acquire riskier assets – has been increasingly employed by speculators since the 1990s, and appears to have played a key role in the speculative period of 2004-2008.

Speculators engaging in this activity are taking risks (sometimes massive risks) with (for the most part) Other People’s Money (OPM). When it works, they return the borrowed funding currency plus interest, and pocket the difference. When it goes terribly wrong, you wind down operations and hide from your creditors behind a corporate liability shield, forcing them to write down the value of their loans to you (their funding currency assets).

Nice work if you can get it, and amazingly, investment banks and their subsidiaries have been falling all over themselves to make these loans to privileged clients — including their own proprietary desks and funds — since the late 1990s (in competitive strategy, herd pursuit of bad ideas is usually a sign of an over crowded industry).

Better yet for the carry traders, increasingly lax financial regulation has allowed speculators to lever their carry up to levels not seen before in modern history, meaning they can borrow more money for a given level of collateral, and/or purchase more assets with a given amount of funding currency.

As some of those trades started to go bad in 2008, the result was a breathtakingly sharp and sudden reversal in the key funding currency, the Yen. This can be seen in the circled graph below, along with the following observations:

• The rate of appreciation in the Yen was far greater in 2008 than in the 1997 and 1998 global financial crises. The left most graph shows foreign exchange movements between the Yen and thirty three other currencies during the Asian crisis of 1997. Clearly, forex movements in that crisis were country specific.
• The middle graph shows currency movements against the Yen during the 1998 crisis associated with the Russian sovereign debt default. The appearance of a positive slope is apparent, implying that forex dislocations were due more to speculative behaviors including the rising use of leverage than to country-specific risks (for that we can probably thank the pioneering geniuses at LTCM and their investment bank benefactors).
• The third graph shows the appreciation of the Yen during the recent global financial crisis. The slope, which gives an idea of how sharply the Yen appreciated against those 33 other currencies, is breathtaking. The median interest rate on the target currencies (on the horizontal axis) also appears to have been roughly half of what it was in 1998.

Translating into English, this means that in 2008-09, the Yen appreciated even more sharply than it did in 1998, and against target assets that offered half the expected return of those in 1998. This calls to mind a question we raised recently, which is whether some powerful financial market participants are confusing ”efficient dislocation” with “market efficiency.” That would be understandable after all. History shows that the fatter the economic rents being justified, the more deluded the economic rationales tend to be.

In the BIS paper, the author also notes that carry trade activities are inherently pro-cyclical: borrowing activity tends to push down the market value of the funding currency, while investing activity tends to push up the market value of the target assets, and this will tend to invite increasing levels of speculation until something causes a breakdown.

Higher degrees of leverage make the pro-cyclicality and the eventual fallout that much worse. Unfortunately, while a great deal has been made of John Maynard Keynes’ alleged return in the past year, it appears that the brief 2008-09 resurgence of Hyman Minsky — who warned presciently of such dangers – has already been forgotten.

That “Minsky fade” appears to be supported by the bottom right graph (though admittedly, this case isn’t as strong as the leveraged carry trade evidence discussed above). The negative slope in that graph shows that less than a year later, the Yen depreciated markedly against many currencies, especially against higher yielding target currencies, which runs counter to the aftermath of 1997 and 1998.

The implication is that the Yen carry trade came back on line fairly quickly after financial markets regained their footing. Apparently financial cockroaches are, like their arachnid namesakes, largely immune to the effects of fallout. As described by the BIS author:

…with extreme risk aversion abating, carry trade activity – a relatively risky strategy – may have returned in the second half of 2009. Indeed, carry trades in a number of high-yielding currencies, especially those of commodity exporters, provided extraordinarily high ex post returns over this period. Moreover, near zero interest rates prevailed in many major currencies, increasing ex ante profitability not only for traditional funding currencies such as the yen. Carry-to-risk ratios support this conclusion…

A a critically important aspect of this issue is financial regulatory reform. Very little has been done from a regulatory standpoint to bring down the astronomical leverage that was available for carry trade speculation prior to 2008. Yesterday, Larry Summers gave an interview to CNBC in which he emphasized that the scope of the proposed “Volcker Rule” was limited to particular types of banks.

If true, over leveraged areas of global financial markets are likely to continue escaping prudent regulation, which means that the pronounced cycles of euphoria and distress in risky asset classes will continue. While those swings create opportunities for contrarian investors, the dynamic behind them is a zero-sum or even net-negative economic game. In the long run, it causes more economic harm than it’s worth.

And while interest rates have converged substantially since the 1990s, current spreads are likely to persist in the decade ahead for multiple reasons, not least being variation in demographic cycles, which will mean lower nominal rates in most developed countries, and higher rates in most emerging markets.

In other words, the roach bait isn’t going anywhere soon. That means that sound regulation absolutely must fill the void in order for the gains from financial market speculation to approach something resembling a social optimum.

UPDATE 3/2/2010 – AP report on further progress in Senate Finance on financial regulation

URLs:

http://www.bis.org/publ/qtrpdf/r_qt1003f.pdf?noframes=1

http://symmetrycapital.net/index.php/blog/2010/02/wsj-hedge-fund-career-trades/

http://news.yahoo.com/s/ap/20100302/ap_on_bi_ge/us_financial_overhaul

Dollar Strength & Foreign Credit

We came across an interesting piece on the relationship between the USD and commercial credit activity outside the U.S., as shown in the chart below. The implication, based on a quick and dirty visual analysis, is that if USD strengthening continues (the red line, which is plotted inversely), then foreign commercial paper (the blue line) is likely to contract. In other words, a dearer dollar could spell trouble for foreign economies, and that would have negative implications for economic activity, commodities, and risky assets abroad, all else equal.

This piece of evidence, combined with our strong dollar call yesterday, raises some fascinating possibilities. A rush to the USD was not on many strategists’ radar in 2009, or even to this point in 2010. Judging by markets’ performance today and yesterday, we could be seeing a significant break from those views. Then again, we might just be seeing the first notable stock market correction since last year; a USD squeeze might also be a short lived phenomenon.

We see too many moving parts to make a firm call either way. The markets continue to face the spectre of tightening federal purse strings and a ‘less easy’ Federal Reserve in 2010, and as of this week, they are now sitting in the middle of the open conflict that has broken out between the administration and the financial industry.  

We also see complexities in that battle that make it hard to come down on either side. We offered criticism of Obama’s initial remarks on the financial assets tax, though we later qualified it, and some of his remarks today were spot on. And while government policies and institutions certainly set up incentives to greed and stupidity, the actions embodying greed and stupidity (and the massive trading of rents that did little or nothing — arguably less – for economic welfare) were taken by individuals and organizations in the financial industry. And yet the overall tone of hawkishness from policymakers has negative implications for everyone, regardless of what street they make a living on.

There’s also a little noted irony in the apparent desire of some Democrats to constrain the size and activities of the financial sector. If Ajay Kapur’s research is on the mark, the sector is going to be shrinking in the years ahead regardless of regulatory changes, due to the shrinking ratio of middle aged adults.  A more interesting thing to speculate on, given the continuing centrality of the USD in the global economy, is how well those faster growing regions of the world will cope with tigher global liquidity. 

[UPDATE 1/21/2010 - In a CNBC interview moments ago, House Financial Services Commitee chairman Barney Frank put a far kinder and gentler spin on the recent presidential bluster, saying that a regulatory regime shift would have to be drawn out over several years and do a minimal amount of harm. This appears to have calmed frayed nerves in the market, and is a nifty scoop for Burnett and Cramer. Cramer's inferring that Paul Volcker (a man with a history of bull-in-a-china-shop approaches to policy) has the President's ear, while Frank comes down with the more nuanced regulatory views of Fed and Treasury, which could make for some political drama in the year ahead. It could even be a high stakes game of good cop, bad cop -- time will tell.]

http://shadowcapitalism.com/2010/01/20/the-implications-of-a-dollar-squeeze-on-foreign-banks-credit-access/

http://www.miraeasset.com/data/download.jsp?file_path=upload&file_name=MiraeAsset_TheGlobalInvestigator_20090812.pdf

http://www.cnbc.com/id/15840232?video=1340630859

http://www.cnbc.com/id/34979114/site/14081545

A Strong Dollar Call

President Obama, continuing his recent streak of verbal fiscal hawkishness (our view is admittedly contrarian) signed a memorandum today regarding tax delinquencies among government contractors. To the extent that federal contracts are awared to tax evaders and tax cheats due to poor information sharing or availability, this is a good initiative, and it’s based on analyses from the GAO like this one.

It was the President’s remarks that were most telling, especially his argument that the federal government needs to align itself with the values and norms that tax paying households live by (of course, this completely ignores the fact that only the federal government can create the money required to fulfill tax, debt, and other financial obligations, not just of the public sector, but of the private sector as well). The underlying message of recent remarks by the President is that tightening via “fiscal discipline” is very likely in the months and years ahead; Obama is clearly signalling that he has staked out a very center-right position among Democrats, similar to the Blue Dogs and Democratic Leadership Council, as summed up in this recent piece by Harold Ford, Jr:

The ability of the private sector to produce new jobs — our economic future — depends on how quickly we can get back on the path to fiscal responsibility. This means that any health-care reform plan should be paid for — a promise that President Obama has made, and one that his predecessor should have made.

Ford’s assertions are based on the rather shaky assumption that they hold under all economic conditions. But as we’ve noted recently, there are only some environments where this holds true, while there are other environments where it does not. In the former, fiscal conservatism may be appropriate due to “crowding out” and other concerns. In the latter, the private sector’s capacity to produce jobs actually depends on public sector demand, investment, and intermediation, i.e., deficits. 

Most people, Ford included, accept this idea in the short run, e.g., during a financial crisis or a sharp economic downturn. But what we’re arguing, essentially, is that pessimistic expectations are sometimes rational, and that the factors driving them can theoretically remain in force over fairly long cycles of ten, twenty, or thirty years, even longer.  In the situation at hand, when we look at demographic shifts in the U.S. and residual damage from the financial crisis, we think the decade ahead will be of the latter variety in both the U.S. and mature European economies.  So the message of Ford, his fellow Blue Dogs, the DLC, and President Obama (especially of late) might be a suboptimal direction for policy, however well it might have worked in the 1980s and 1990s. [1/20/2010 UPDATE - well written piece here on how public thinking about policy is heavily informed by experiences since the 1980s, which might be akin to driving by the rear view mirror]

As a result, we now see several forces at work that lead us to expect a strengthening USD, all else equal. First, the prevailing view among Democrats appears to be that voters will favor fiscal hawks in midterm elections, and they will respond accordingly. Second, we expect upside volatility in the real economy in 2010 (due in no small part to public sector demand), which will relax pressures for additional fiscal stimulus. Third, invoking the ideas of the neo-Chartalists, we’d argue that when the federal government places a high value on “fiscal responsibility” or “fiscal conservatism”, it implies that monetary units are going to become more scarce, and thus more valuable. In other words, if the President’s recent signalling is sincere, the USD is likely to appreciate (as will Treasuries, despite their compressed yields), and commodities and other carry trade and risky assets are likely to suffer (today’s market movements seem to support this argument).

While most pundits are attributing today’s market developments to the Republican capture of Kennedy’s senate seat yesterday, and/or to policy tightening in China, which are almost certainly factors, we would argue that far too many are overlooking the impact that President Obama’s current policy tenor is having on the USD. He’s essentially promising that the “tokens” required to settle economic transactions and engage in productive activity are going to become scarcer.

This implies some important changes in who the marginal actors are in the political economy. After the 2008 election, we asserted that the Blue Dogs would be the marginal player in setting the course of economic policy. The President’s upcoming budget will give us a clearer idea of whether their fiscal conservatism, as Obama’s current rhetoric implies, has indeed become dominant. If it has, then we think the Fed becomes the marginal factor in policy direction and economic outcomes. How soon and how sharply they tighten will determine the risk of a 1937 or Japan style recession, and it will also have critical implications for the performance of emerging market equities and other risky assets in the short to intermediate term.

URLs:

http://www.whitehouse.gov/the-press-office/memorandum-heads-executive-departments-and-agencies-1

http://www.gao.gov/new.items/d07742t.pdf

http://www.dlc.org/ndol_ci.cfm?contentid=255070&kaid=85&subid=65

http://en.wikipedia.org/wiki/Chartalism

http://www.cfeps.org/pubs/wp-pdf/WP10-Wray.pdf

Idle Speculator: Payrolls, Policies, Politics

Friday morning’s report on the employment situation had a little bit for everyone, bulls and bears alike. November revisions saw the first positive month for payroll growth since the current recession began, and the “less bad” trend remains firmly intact. However, the number of discouraged workers jumped dramatically, and payroll growth is still far too low to significantly bring the unemployment rate to a persistently lower level. While unemployment continues to pose a risk to Democrats in 2010, neither party is making a compelling offer to the electorate at the moment, and both of them are too focused on scapegoating the other. While we expect some positive economic surprises in 2010, the U.S. electorate and economy will remain stuck between an elephant and a donkey for some time.

Continue reading: http://symmetrycapital.net/idlespeculation/20100112.pdf

The Curiously Gloomy Narrative Continues: Obama’s ‘Lack of Leverage’ over China

The Philadelphia Inquirer has an interesting front page article on the various issues negotiated between China’s President Hu and our President Obama during the latter’s recent visit to China. The article’s title proclaimed that “Obama finds he holds little leverage in China”, noting:

President Obama today wraps up a three-day visit to China that has left him keenly aware of the limits of his administration’s leverage over this economic powerhouse on issues from currency-exchange rates to human rights.

That characterization sounds a bit too pessimistic to us, and it’s yet another example of the curiously gloomy narrative that has developed in the U.S. media around our relationship with China. We can assess the article’s assertion by comparing the issues that each President  brought to the table.

China would like the U.S. to: 

• Tighten Federal Reserve policy in order to support the value of China’s U.S. dollar and debt holdings, and lower inflation risks in China;
• Avoid raising barriers to trade between the two countries;
• And avoid seeking stringent curbs on CO2 emissions from developing economies at the upcoming Copenhagen summit.

Meanwhile, Jon Huntsman, the U.S. Ambassador to China, was quoted as saying that the U.S. was focused on “key global issues”. President Obama requested that China:

• Allow its currency, the renminbi (RMB), to strengthen against the USD, and moving closer to a floating exchange rate regime;
• Expand human rights protections and limit state censorship;
• Commit to shouldering its share of the burden in combatting climate change;
• And help “contain the nuclear ambitions of North Korea and Iran.”

Look at those two lists and ask yourself which country’s well-being was most on the line. Hu’s requests were aimed at preventing major economic burdens from being imposed on China by entities outside of China.  But other than the impacts that a stronger RMB could have on U.S. exporters, Obama’s requests were aimed at the distinctly non-U.S. issues of climate change, nuclear proliferation, and China’s dealings with its own population!

For several years now, the media’s prevailing U.S.-China narrative has hung on the fact that China is a major holder of U.S. debt, and that this is somehow “unsustainable”. While the last decade’s rate of accumulation may be unsustainable, the current situation is more benign than many assume. And even if the situation were dangerous, China’s position is just as precarious as ours. That’s especially true when you compare productivity and per capita income levels in the two countries (military strength is also a factor), as well as secular and political shifts in the U.S. economy.

The story also tried to make something out of the fact that neither President Hu nor students attending Obama’s Shanghai townhall meeting showed much emotion. If that were a cultural anomaly in China, we might make something of it. It’s not, so we don’t.

All in all, there seems to be little basis for the claim that President Hu had the stronger hand.

URLs:

http://www.philly.com/inquirer/home_top_stories/20091118_Obama_finds_he_holds_little_leverage_in_China.html

http://news.yahoo.com/s/ap/20091118/ap_on_bi_ge/climate

http://symmetrycapital.net/index.php/blog/2008/12/

Budget Jawboning, Right on Cue

In our most recent Idle Speculator, we argued that there’s a risk that the federal government begins to tighten the screws on the real economy too soon, which could cut short a nascent recovery, much as it did in 1936-37, and much as the Japanese government did at different times during Japan’s two decade recession. Right on cue, the Obama administration has announced that it wants to freeze or cut most domestic spending:

The Obama administration, mindful of public anxiety over the government’s mushrooming debt, is shifting emphasis from big-spending policies to deficit reduction. Domestic agencies have been told to brace for a spending freeze or cuts of up to 5 percent as part of a midterm election-year push to rein in record budget shortfalls…

[The President] is expected to make post-recession spending restraint a key theme of his State of the Union address in January and an important element of the budget he submits to Congress a few weeks later. He is under increasing pressure, including from moderate and conservative members of his own party, to show he is serious about tackling a deficit that has become both an economic and political liability.

What direction this will take is still up in the air. As the AP article points out, the move is in response to political pressures rather than economic conditions, which do not argue for a more hawkish budget. Thus, the effort might have more symbolism than substance. However it’s pursued, the primary objective appears to be the Dems’ chances in the 2010 Congressional elections, which smacks of politics-as-usual, short run consequences to citizens — whether it’s economic harm or just being lied to — be damned. Is that somehow a better recipe for electoral success than speaking honestly with your constituents about the appropriate times, places, and levels of public expenditures?

We understand the thinking that sees common sense in a balanced federal budget, and under certain economic conditions, tightening at the federal level is absolutely appropriate. But to demand a balanced budget under current economic conditions is probably not in our best interests,  especially if it includes sacrificing public investments with significant multiplier effects and/or taking tax reforms off the table. Furthermore, it would take away any room that the Federal Reserve has to tighten monetary policy, which will only exacerbate the USD carry trade that seems likely to fuel another round of commodity and emerging market speculation; that would mean yet another bout of global financial upheaval at some point. Economist Nouriel Roubini recently argued that current financial and monetary conditions could lead to the “biggest co-ordinated asset bust ever…if factors lead the dollar to reverse and suddenly appreciate.” A vigorous tightening of the federal budget could certainly catalyze such a reaction. Putting it all together, it appears that instead of helping the Federal Reserve alight from its tightrope, Congress and the Administration are choosing to step onto a tightrope of their own.

Before expressing their will in 2010, voters should keep in mind that day-to-day common sense would have called for letting large financial institutions fail in 2008, which would have short circuited the global payments system (imagine having to barter or transact in personal IOUs from September 2008, and what effects that would have had on the economy). It is important to signal to foreign Treasury debt holders that their interests will not be ignored (we’re speculating that this could have been a concession to China and Asia). And there will come a time when federal budget tightening is appropriate. But by our reckoning, that moment is not upon us yet.

URLs:

http://symmetrycapital.net/idlespeculation/20091109.pdf

http://finance.yahoo.com/news/Obama-wants-domestic-spending-apf-691348121.html?x=0

http://www.rgemonitor.com/roubini-monitor/257912/mother_of_all_carry_trades_faces_an_inevitable_bust

Idle Speculator: Is the Federal Government Too Tight?

In our latest Idle Speculator piece, we ask whether — despite large recent and expected budget deficits — the federal government risks being too tight. We argue that:

(1) At certain times and under certain economic conditions, deficit financed improvements in the tax code and public expenditures and investments make sense.

(2) The U.S. may be in one of those periods now, while Japan may be exiting one. In both cases (as well as the Great Depression), demographic trends might be playing a larger role than conventional theories assume.

(3) Pro-growth fiscal policies would give the Federal Reserve a lot more room to raise rates and defend the USD.

(4) Given: the enormous nominal dollar figures attached to discussions of U.S. budget deficits and national debt; widespread misconceptions about public finance and its economic effects; and ideological rancor among voters and politicians; there will be increasing pressure to tighten up the federal budget in coming years. Such actions could be premature and threaten a nascent economic recovery.

http://symmetrycapital.net/idlespeculation/20091109.pdf

Tasker: China following in Japan’s footsteps?

China analyst Peter Tasker in the Financial Times:

[In the late 1980s, while] the western world was stuck in the post-crash doldrums, the Japanese economy had got back on track with apparent ease. Japanese corporations were using their high market capitalisations to finance acquisitions of foreign trophy assets. Japanese banks boasted the world’s strongest credit ratings.But what you saw was decidedly not what you got. The crisis, far from leaving Japan unscathed, exacerbated its structural problems and laid the groundwork for a far greater disaster. And it was the weak western economies, not Japan, that produced healthy investment returns over the next decade.

[Japan's] current account surplus and strong fiscal position provided the macro policy leeway to make any slowdown strictly temporary. The Bank of Japan duly put the pedal to the metal and the recently deregulated banks went on a patriotic lending spree. High-end consumption boomed but the real action was in the asset markets and capital investment, which soared as a proportion of gross domestic product.

Sound familiar? It should, because the same dynamic is evident today in China and some other emerging economies.

Tasker then invokes turn-of-the-20th-century economist Wicksell, a favorite of ours:

If the natural interest rate is, as the Swedish economist Knut Wicksell posited, around the level of nominal GDP growth, then China’s interest rates should have been close to 10 per cent for most of this decade. Alan Greenspan, former chief of the US Federal Reserve, has been criticised for holding interest rates too low and setting off a housing and credit bubble in the US. But if US monetary policy was wrong for the US, it was even more wrong for the high-growth countries that “imported” it. The result could only be a massive misallocation of capital.

Tip of the hat to the truly prolific Ed Harrison at the Credit Writedowns blog. On a related note, one of his colleagues, Marshall Auerback, is the first analyst we’ve come across who’s aware of the continuing significance of China’s yuan devaluations in the early/mid 1990s:

…between 1992-94, China devalued the RMB by close to 60% (she was already running a current account surplus when she did it the second time), which created huge competitive pressures for the other [Asian] countries and pushed them rapidly into deficit.  This time, China is devaluing along with the US dollar and reflating a credit bubble — not to encourage domestic demand, but to create a renewed export juggernaut, at a time of weak external demand.  This could really be problematic for the rest of the world.

I wonder how long before the protectionist pressures emerge?

All fair points, though Chinese authorities seem to be aware of the multiple risks they’re facing (whether they can manage them effectively is another question). But there’s another factor that might be just as important, and that’s demographics. The age composition of China’s population is trending in a direction that is not conducive to sustained 10%+ GDP growth.  Other BRIC  members should see more favorable demographic trends, with Russia the true standout. Russian markets also happen to sport the highest risk premia compared to Brazil, India, and China.  

URLs:

http://www.ft.com/cms/s/0/39f61cb6-c818-11de-8ba8-00144feab49a.html

http://www.creditwritedowns.com/2009/11/china-is-now-on-the-same-bubble-path-as-japan-post-1987-crash.html

http://www.creditwritedowns.com/2009/11/china-reflation-play-spells-trouble-for-rest-of-the-world.html

http://www.miraeasset.com/ourmarket/outlookView.do?board_id=1125&group_id=1&pageNo=1

DISCLAIMER and IMPORTANT DISCLOSURES: Symmetry Capital Management, LLC is a state registered investment advisor. The foregoing information is for informational, educational, or entertainment purposes only. It does not constitute an offer to buy nor a solicitation to sell any security, or to engage in any investment strategy. At the time of writing, the firm, its principals, and its clients did not own any securities mentioned, or any securities issued by corporations mentioned. Symmetry Capital Management, LLC is an Amazon.com associate, and may earn a percentage of any sales generated by clicking through to the Amazon.com website from links on our website.

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

Convergence Divergence

We subscribe to the idea of long run convergence in the global political economy, but sometimes an incident reminds you of how far things still have to go. This one’s by way of India:

NEW DELHI (AP) — A police inquiry was launched Tuesday into employees from Continental Airlines after a former president of India was frisked before boarding a flight to the United States.

The airline’s staff violated a government order on protocol for dignitaries when former President A.P.J. Abdul Kalam was told to remove his shoes and scanned by a metal detector, Civil Aviation Minister Praful Patel told Parliament.

Patel said airlines are given a list of Indian VIPs who should be exempt from searches.

“This act of frisking the former president … is absolutely unpardonable and beyond the scope of the laws of our country,” Patel told Parliament.

Lawmakers condemned the search of the 77-year-old Kalam as “outrageous.”

OK, not totally outlandish. After all, the guy’s flying commercial, unlike some of our ex-dignitaries. But here comes the scary part:

In a police complaint, the aviation ministry accused Continental’s staff of violating government directions, an aviation ministry statement said.

“If convicted, the staff members can be jailed for two years or fined 1 million rupees (US$20,830), or both,” said Moushmi Chakravarty, the ministry spokeswoman.

Wow!!! Up to two years jail time for inconveniencing someone? Apparently there’s yet another class of “Untouchables” in India…

DISCLOSURES: The foregoing is for informational purposes and/or entertainment only. It is not an offer to buy or a recommendation to sell any security, or to engage in any investment strategy. Some clients of Symmetry Capital Management, LLC hold securities issued by Continental Airlines.

URLs:

http://finance.yahoo.com/news/US-airline-probed-after-apf-1181104551.html?x=0&.v=1