Dollar Carry Trade Hitting Brakes?

Sunday’s Financial Times hosted another polemic on “the mother of all carry trades” from Nouriel Roubini. He’s worried about another asset bubble fueled by cheaply borrowed dollars that apparently could remain cheap for an “extended period,” according to the Fed.

This, as all FX traders know, has a multiplier effect because when a carry trade goes really well, you get the double-whammy of the interest rate spread and the currency appreciation. The example I have highlighted here most often this year is the Australian dollar, which gains against the dollar as it also earns the 3% difference in rates (see my pieces The FX Carry Trade and Currency Carry = Interest Arbitrage).

Roubini points out not only how dangerous this is for the leveraged “bubble traders,” but how bad it is for a real economic recovery. As the US dollar bumps along near its historic lows, he theorizes that what is occurring is more like traders borrowing at negative 10% or 20% to buy oil, gold, euros, and our favorite risky asset — equities.

When this bubble pops, it will hurt more than the traders, he argues. “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.”

Translation: We are building leveraged risk into the system all over again—the same kind of leverage that took down Wall Street financial institutions and ultimately threatened the portfolios of Main Street.

He goes on to describe the artificial support this bubble is getting from the Fed’s quantitative easing asset purchases. This adds to the instability of the trade because the yield curve is held unnaturally low, much like a stretched rubber band. I wrote about this last week in Dollar as Scorecard and Symptom when I quoted Axel Merk:

“… if the Fed helps to engineer that markets cannot price inflation into bond prices, there has to be a valve. This valve… will be the US dollar.”

Reversal, Stampede, Collapse

In a single paragraph, Dr. Doom uses these three nouns to describe what’s coming when this giant carry bubble pops. The reversal is what happens when the music stops and everybody scrambles for the few open seats. This will come when the Fed finally signals “extraordinary liquidity” and “extended period” are over.

This will not happen at the end of tomorrow’s two-day Fed meeting, by the way. But we have seen it happen before. I saw it in 1998 when the Fed and the Bank of Japan (BOJ) intervened to fight dollar strength and the yen carry trade. They knocked the dollar down hundreds of points from 140 USD/JPY to 130 in a day, costing billions to many firms.

The stampede in this case will happen once the smart money knows the jig is up. Right now, they are confident the carry trade is still in force because the Fed will be on hold for another six to nine months. That’s why oil, gold, equities, and the euro are still up here. We saw a little scramble away from risk and toward safety last Friday when the S&P dropped 30 points, but that was just a test.

The collapse will be brutal he thinks, especially the longer the bubble is pumped with “dollar air.” Not so much for Wall Street this time. Maybe for hedge funds. Definitely for Main Street.

“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.”

Dollar Doom, Not So Fast

Why am I suggesting his panic is extreme and that the mother of all carry bubbles is likely to deflate more slowly? First, because I think Bernanke and Co. have their finger on the pulse of this recovery and will no more create another bubble than they would allow a deflationary collapse that would ever prevent it. That’s what I said in my MarketWatch piece last week.

Second, last night we got another interest rate hike and tempered words from the man in charge of one runaway carry trade, Glenn Stevens, governor of the Reserve Bank of Australia. While the market was baking in at least 50 basis points in raises from the RBA this year, the central bank statement implied that they may now be done for the year with the October and November 25-basis point moves and do nothing further until January or February.

Both the Aussie and the euro reacted strongly to this news overnight and traded below strong support levels at $0.8950 and $1.4680, respectively. This is another bump in the road for the “runaway carry bubble.”

Which isn’t to say that the dollar carry trade is over. Just that it can also unwind slowly too, and not burst like everyone expects.

“Mind the Risk, Bank the Profits!”