November 2, 2009
Nouriel Roubini has written an article in the FT discussing the threat of basically a coordinated deflating of assets that is set to occur as a result of the low interest rate policy in the US. The low interest rates are creating a carry trade opportunity allowing investors to borrow at next to nothing (or as Roubini argues, -20%), and invest the proceeds elsewhere.
This is nothing new, but it does in fact raise asset prices. The carry trade “phenomenon” was partially behind the rising asset prices in the last cycle, with investors borrowing against the Japanese Yen and investing those proceeds abroad (i.e. the US). When the music stops and the currency borrowed against starts to lose its value, liquidity shrinks dramatically.
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.
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