Roubini Says Beware the Carry Trade Asset Bubble

Dr. Doom – AKA New York University Professor Nouriel Roubini – is at it again. The man who is credited with being the first to point to the questionable lending practices that ultimately led to the housing bubble and the global recession, is now taking dead aim at what he believes is setting the stage for the next financial crisis – a US dollar asset bubble.

On Monday, Professor Roubini told CNBC that we are headed for the “mother of all carry trades” as interest rates widen amongst the major currencies. Roubini fears that now that US interest rates are zero-bound, investors will use the US dollar to fund the purchase of higher-yielding currencies – particularly those concentrated in several emerging nations presently benefitting from higher oil and commodity prices. This, according to Roubini, is a “dangerous” game.

Roubini does not believe US interest rates can remain at zero for the long term, and once the recovery is truly established, the Federal Reserve will be forced to fast-track interest rate hikes to fend off the threat of inflation. He also questions the sustainability of current commodity prices – especially oil – which he says is presently overvalued when economic realities are considered.

This warning should give pause to currency trade participants as a rapid US dollar appreciation, combined with a depreciation in the currencies on the other side of the carry trade, would quickly place these trades in a losing position. Obviously, this would lead to a sudden unwinding, sharply increasing demand for the dollar as traders scramble to buy enough dollars to cover their short positions.

The act of closing these carry trades would create the equivalent of a US dollar bubble supported not by economic fundamentals, but simply by the need to cover massive short positions. This bubble, like all asset bubbles, would inevitably collapse upon itself, but the damage could be so widespread that it would likely send the US economy back into recession in a scenario Roubini described earlier this year as a recession “double-dip”.

We need only look at our recent history to find an example of just how quickly carry trades can turn. During the mid 1990s, the Asian currency crisis weakened the yen against the major currencies, and the Bank of Japan responding by dropping interest rates to near zero in order to encourage spending and prop up the yen (sound familiar?). This gave rise to the yen-funded carry trade using very cheap yen to buy Australian and US dollars at a time when the US Federal Funds rate was 5.5 percent. So long as interest rates remained stable and the exchange rate between the two currencies continued to favor a long USD position, investors could profit on the interest rate carry.

Sadly, good things can’t last forever, and in October of 1998, the Bank of Japan implemented a plan to recapitalize the country’s banks boosting the yen by 12 percent – literally – overnight. Meanwhile, the US dollar suffered a significant drop during a stock market correction which caused the US bond market to fall on the same day that the Yen was appreciating. The cumulative effect of these events caused the exchange rate between the dollar and the yen to move so much, that most of the open carry trades were suddenly in a negative position.

This unexpected exchange rate reversal triggered a mad rush to unwind the off-side positions, and many large hedge funds and a handful of high-wealth individuals suffered very public losses. This led to a further sell-off, prompting US Federal Reserve Chairman Alan Greenspan to declare that the world was facing a credit crunch. The Fed responded by dropping the Federal Funds rate by 75 basis points over the span of the next three months, effectively closing the interest rate gap between the two currencies, further compounding carry trade losses. It is the potential for a repeat of this scenario that has Roubini once again taking on the role of Dr. Doom.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.