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Monday, November 9, 2009

What is a Carry Trade Bubble

Nouriel Roubini made a name for himself predicting the mortgage crisis that lead to a financial crisis to. In fact, his predictions were oracle like. Here's what he said in 2006.

September 2006, he warned to a skeptical IMF that: "The United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence, and, ultimately, a deep recession."[2] He also foresaw "homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt"

In fact, looking back, this prediction was remarkable not only in its accuracy but in its detail. He didn't merely predict a housing bubble, but an oil bubble, and the destruction of trillions worth of mortgages.

Mr. Roubini is at it again. He's now predicting the "mother of all carry trade bubbles". So, what is a carry trade?

In a carry trade, investors borrow in countries with low interest rates to invest in higher-yielding assets.

Interest rates are near all time lows in the U.S. Thus, that's one piece of this puzzle. In fact, a carry and trade bubble is just a fancy way of saying that there's too much availability of cheap money. The second piece is a weak dollar. What does that do?

This bet -- known as the dollar carry trade -- appears to be one of the forces pushing down value of the dollar. Though there are few reliable figures on the size of the carry trade, the dollar's trend has clearly been down since stock and bond markets revived.

The buck recently traded at its lowest level against the euro in a year, while the trade-weighted dollar index has dropped 14% since March.

The resulting investment flows are potentially unstable, prompting talk of new asset
price bubbles
-- particularly in commodities such as oil and gold, and the economies of faster-growing emerging markets.

So, what we have is a bubble in foreign assets, gold, oil, and other commodities. It's the "mother" of all such bubbles because we have unprecedented low rates and unprecedented weak dollar. Now, whether or not Roubini is right is a matter of debate for people much smarter than me.

Still, long ago, I said that the Fed keeping rates near zero and keeping both mortgage and treasury rates artificially low was fueling a bubble. To understand how dangerous this think about this. One of the things that fueled the sub prime crisis was the availability of Fed Funds Rates below one percent and the ability to turn that money around and lend it at 8-9- and 10%. That spread was very enticing and it was a major factor in creating the sub prime bubble.

Bubbles are created in a number of ways. One of those ways is when something is manipulated to create an abundance of stimulation. The ability to borrow artificially cheaply gives people an incentive they wouldn't normally have to invest in equities they normally wouldn't. The Fed has now kept the Fed Funds rate at zero for nearly two years. That's an obscene amount of hyperstimulation. That has consequences. So, I don't know if there is a carry and trade bubble forming however I firmly believe that a bubble is forming.

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