Last February (and again in May) I wrote about the intertemporal carry trade on the dollar being undertaken by the Obama administration and the risks associated with that. Nouriel Roubini has taken that ball and run with it:
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. ...
So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles. ...
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.
Here's how this basically breaks down: because U.S. interest rates are so low while the dollar is falling, investors can borrow dollars and sell them for other assets, thus making a tidy profit for doing basically nothing. Roubini's point is that these "other assets" are risky assets across the globe, and the increased demand for them has created a bubble that will necessarily reverse when the dollar stops falling. This assumes that the prices of these risky assets -- equities, commodities, etc. -- are inflated, and there is a lot of room to fall when the dollar rises (and indeed, that the dollar is currently under-valued or close to it).
But considering that asset prices are still well below their peaks, it is possible that there is still slack in the system, and the increased demand for these assets reflects some of that slack being tightened. In other words, the return of demand for risky assets reflects sentiment that Roubini describes as "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." Roubini sees this rise as precipitously steep rather than gradual. He may be right. But it's not clear that we should freak out just yet. Asset prices dropped much more than they probably should have last fall, and the dollar rose much more than it should have. Part of this is a simple correction. Couple that with the fact that the global economy has stepped back from the precipice, and there are good reasons for the rapid bounce-back in asset markets that we've seen.
To be sure, there is a real danger that we'll overshoot again. But Roubini expects "the biggest co-ordinated asset bust ever" yet asset values remain somewhat depressed. And while it's true that the value of the dollar cannot fall to zero, as Roubini says, it is similarly true that all asset value cannot fall to zero. Even if we gave up all the gains made in March, we'd be right back where we were in March and the fall would be less severe than the Sept.-March collapse.