Thursday, November 5, 2009

Be-aware of the carry trade

in a article first posted in the Financial Times, Nouriel Roubini has warned of an impending burst of the carry trade bubble...what follows is exerpts from and links to a few articles from MSM, as well as analysis from blogs to give you an idea whats going on...

Carry trades - the Economist - To the extent that carry trade (ie speculative) financing is supporting money growth, the Fed could be deceived into thinking monetary policy is looser than it really is. That could set up the markets for a nasty shock, in which the Fed signals an end to accommodation, the dollar surges, and the carry trade reverses. In such circumstances, not only would asset prices fall but the higher dollar would tighten US economic conditions at a very awkward moment

Mother of all carry trades faces an inevitable bust - 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.

Roubini warns risk assets 'party' may end abruptly - Over the past year, the dollar has increasingly been at the center of a so-called carry trade. With interest rates effectively at zero in the U.S., global investors seeking risks and higher returns are increasingly borrowing risk-free dollars to invest in higher-yielding currencies and assets, such as stocks, commodities, and emerging markets. These trades have kept putting pressure on the dollar as investors short the currency to invest elsewhere. The big rally seen over the past year in stocks, commodities and other risky assets, are all the same trade, Roubini said. And it's been exacerbated not just by the Fed keeping rates near zero but also with the Fed buying Treasurys, keeping rates low not just at the short end but also at the long end, thereby reducing volatility. "When it unravels, it's going to get ugly," Roubini said. "Everyone that's shorting dollars will try to get out of those positions at the same time, and we'd have a stampede."

Roubini On The Dollar Carry Reversal, And Why He Is Only Half Way There - Nouriel has a great op-ed in the FT, discussing the imminent reversal of the dollar carry trade, a topic Zero Hedge has been harping on for quite some time: not because we believe that in the long run America will stabilize its economy (on the contrary), but because in a globalized economy (yes, a sad side effect of $1.4 quadrillion in derivatives is the fungibility of declining asset leverage) economies are relative, not absolute concepts. While our biggest pet peeve has to do with the lack of contrarian thought in whatever the groupthink trade de jour is (when everyone is on the same side of the boat, it always inevitably capsizes), Nouriel is similarly unimpressed with what he sees is doomed to end badly for so many institutional and retail traders who are part of the herd mentality. Never one to mince words, Roubini's conclusion is scary…

Did We Learn Anything? Carry Trade Edition - My concern now is that it appears we haven't learned anything from the turmoil that happened all of 8-12 months ago. As Nouriel Roubini recently pointed out, the correlation of all risk assets has approached one as all assets have all moved in one direction... up. Why? One reason is the world's investors are turning to the US dollar for their carry trade currency of choice (if you haven't read it yet... READ IT). At a high level it goes like this... the dollar's decline is a one way bet. So why wouldn't a foreign investor: Borrow the dollar at a 0% rate. Plan to pay the dollar back at some point in the future when it is worth 10-20% less in their local currency. Use that money to invest in ANY risk asset (as long as the asset doesn't lose more than gain on the dollar short, the investor wins... so why not ratchet up the risk?) The issue is that at some point the dollar may not even reverse its decline, but will stabilize, increasing the "real" cost of borrowing the dollar... if the correlation of assets purchased is near one on the way up, it is sure as hell going to be that high or higher on the way down. And what happens to all these investors that are attempting to leave the same exit door at the same time? Massive re-purchasing of the dollar and massive selling of any risk asset... joy.

The roots of the coming crash - Now, along comes Nouriel Roubini to burst my bubble. This isn’t a case of the weak dollar making asset prices look good; in fact, it’s the “mother of all carry trades”, setting up “the biggest co-ordinated asset bust ever”. I believe him. Nouriel’s analysis is quite compelling, given the way the carry trade works. In its most harmless form, people borrow at low rates in a funding currency and then invest the proceeds in a higher-yielding target currency. When that trade starts becoming crowded, the flow of money into the target currency causes that currency to rise, which makes the carry trade even more profitable — you not only pocket the spread between the two interest rates, but you also get a capital gain on the fx trade. But this carry trade is even stronger still: not only are the target currencies rising, but the funding currency — the dollar — is falling. Players are making money on three different legs at once, and that means they can start investing not only in foreign currencies and local interest rates, but rather in a whole panoply of other asset classes, including commodities, energy, junk bonds, even equities. These assets might not yield much, but they don’t need to, if the funding currency is falling fast...

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