Roubini: Mother of All Carry Trades Faces Bust

A: As discussed right here 3 days ago when talking out loud about the extreme positive carry trade that is on what may happen if that reverses!! Professor Roubini gets into details.

Professor Nouriel Roubini discusses, "Mother of all carry trades faces an inevitable bust", in FT:

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.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

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.

Told ya he goes into details! The professor lists 4 main reasons WHY the carry trade will 'unravel':

1. The US $ cannot fall to zero
2. The fed cannot suppress volatility forever
3. Markets might force the fed's hand into tightening on better than expected data
4. A flight away from risk and into safety

All would trigger a dollar rally and hurt those aboard the carry trade gravy train. I discussed #3 above a few weeks ago. Who knows what may force the fed hands...

So how do we know if it might be happening? You'll know. The US dollar will make a fast and fierce move to the upside on practically no news feeding the unwind further. Then other markets can react. Similar to how new highs make usually make higher highs as shorts cover positions which further powers the upward momentum - the same trading pressures can occur on an unwind of a very crowded trade.