Mother of All Carry Trades Faces an Inevitable Bust
By Staff News & Analysis - November 03, 2009

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 annualized – as the fall in the US dollar leads to massive capital gains on short dollar positions. – Financial Times

Dominant Social Theme: Policy is reckless, not the system.

Free-Market Analysis: Even when the British Financial Times – a preeminent mouthpiece of the monetary elite – tries to give us an unvarnished look at the world economy it ends up fudging it in our humble opinion. Let's try to unravel the above excerpt to figure out exactly what the problem is that the Financial Times perceives and whether it is complementary to a the kind of free-market analysis we try to offer readers.

First of all, we have to note that the article is labeled opinion and is written by one of the best (and most bearish) of mainstream analysts: Nouriel Roubini – who has been right and right again during this latest, ongoing economic crisis. Roubini, like Peter Schiff, has become one of the few who are able to speak truth to power in the pages of powerful journals. But even here one gets the feeling that the few such as Roubini are trotted out mostly to astonish, and to assure readers that both sides of the story are being covered. In any event, as the grouchy genius Samuel Johnson (it is certainly appropriate to quote him in the context of an FT article) once said of the Quakers: "Sir, a woman's preaching is like a dog's walking on his hind legs. It is not done well; but you are surprised to find it done at all."

And yes, Roubini, despite the honesty of his views, is well schooled in how to write in a way that cleaves to the mainstream conversation. What he says is discomfiting but he uses mainstream Keynesian rhetoric to promote his discomfiting analysis. What leaps out at us first of all is the conflation of gold and silver with "risky" assets. How do we know that the article is including gold and silver with the appreciation of risky assets? Because Roubini goes out of his way to include "commodities" in his litany of over-extended assets. Gold and silver have appreciated a good deal in a short time and we would be most surprised if Roubini did not have these two assets in mind when mentioning commodities along with stocks and oil.

Our quibble? From our quasi-Misesian point of view gold and silver are distinctly NOT like oil, energy, stocks, bonds or any other "investment" currently available. As we've pointed out in the past, the business cycle is like a teeter-totter with first fiat money and then gold and silver moving up and down. Fiat money's turn usually lasts longer than gold's and silver's because the monetary elite does everything it can to keep fiat going. But sooner or later the market comes down hard on the side of gold and silver and the teeter-totter moves.

Gold and silver are thus DRIVERS of the global economy at a certain point in time. Now is such a point. Bonds and stocks are not driving the global economy. Oil is not driving the global economy. Almost everything the monetary elite is doing right now via its central banks has to do with suppressing or at least retarding the price-rises of gold and silver. Seen from this vantage point, gold and silver are not "risky" and their price rises – or rather the fall in the value of fiat currencies such as the dollar – are inevitable. Let oil go up and down. Let stocks rise and fall. It happened in the 1970s as well. Gold and silver continued their price rise until the end of the decade. That's how it works when the teeter-totter switches its position. It has nothing to do risk and everything to do with the fundamentals of free-market economics.

Having written the above, of course, we would hasten to add that we are not predicting that gold and silver will have a smooth ride to the top. The only constant in price appreciation is variability. And then there are the antis to take into account. The anti-gold and silver crowd is a formidable array indeed. The only ally that gold and silver have is the marketplace itself, and the business cycle. This will prove enough in the long term. Though, it also true, as Keynes famously said, "in the long run we are all dead." (Sorry, we will stop quoting now.)

What we should bear in mind is that the elite is apparently struggling to save the fiat money system after the worst crash since the great depression. They may once again be able to salvage the system, but, gosh, it is getting most difficult. The powers-that-be have ended up throwing tens of TRILLIONS into the marketplace. This was done during the Internet information age, so everyone saw what was going on. The unfairness of the system, where a handful of white, European men control trillions while most everyone else (those who are not part of the system via, say, accounting, law or public education) scratches out a living as best as is possible.

Watching the reactions of the monetary elite is like gazing at a pinball machine. One problem provides a reaction somewhere else. A bumper pings and an insider trading case is prosecuted against a Jewish power-broker, or the former President of France is prosecuted after a judge on the case is over-ruled. We are too cynical these days to believe this is serendipity. The elite knows that its game has been played out in the public eye. And the game, as we have said for several years now, is up. The show trials of a few famous men will not dissuade the opinion of at least a sizeable minority that the system is infinitely corrupt. In fact, thanks to the ability of a few to fix the price and quantity of money, it is.

What is another quibble we have with Dr. Roubini? It is perhaps an unfair one. He uses the rhetoric of central banks to damn the process with faint praise. Daily Bell readers knew long ago that central banks were fueling another asset bubble and also that commercial real estate and derivatives remained a looming problem because asset inflation did not create jobs. Now Roubini shows us that ALL the world's assets are inflating in tandem thanks to a huge asset bubble, the mechanism of which is the "carry trade." It is inevitable, he writes, that the carry trade (which borrows rock-bottom dollars to invest in almost any asset) will come to an end once the dollar comes off the ropes.

While we still believe that the system itself is due for a collapse (in fact it virtually has) we must admit that those who print the money may stave an entire implosion for at least a while longer. (Days, weeks, months?) We are not such fools as to predict a timeline, only to say that history shows us that fiat money systems inevitably collapse. This one is well on its way to doing so.

Roubini won't come out and say it though. The Financial Times would be uncomfortable with such frank talk. Instead, Roubini is back to the old game pursued by so many otherwise honest individuals of chiding central bankers – especially the Federal Reserve — for "reckless" policies. For goodness sake's the recklessness is inherent in the system. The system IS reckless. This, Roubini simply can't bring himself to write. (Or maybe he did write and the esteemed FT editors removed it). Anyway, here's some more from Roubini:

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. …

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.

Above, we find yet a third reason to quibble with the Good Doctor. The Fed and other policymakers are not "unaware" of the "monster bubble they are creating." If they want to support the decrepit fiat money system and cling to the privilege of printing money they have to risk other problems. They have no choice but to reflate, thus creating a financial bubble that will cause even more damage when it pops than the most recent one. If you thought 2008 was bad, just wait.

After Thoughts

The system really stinks, not to put too fine a point on it. It doesn't smell when everything is going up over a long period of time. But these kinds of yo-yo boom-bust episodes are terrible for a system that the monetary elite sells based on its stability. The old remedies being trotted out – increased globalization, increased regulation – aren't sticking because of the Internet and a rising tide of financial literacy. Globalization is of course a solution that will only make the problem even worse. The real solution is a privately based gold and silver standard. It is one that the market would revert to absent the eternal, inevitably doomed, meddling of the monetary elite. We bet Dr. Roubini would agree were he writing in the pages of a journal other than the FT.