Roubini: Mother of all carry trades faces inevitable bust

Yesterday the Financial Times ran an article from Economist Nouriel Roubini warning of global asset bubbles that have been simultaneously re-inflated courtesy of the falling US dollar since March. As the U dollar fell against most of the world's currencies, traders have borrowed U dollars at negative rates to buy pretty much any and every other asset in the world. The more reckless the risk taking, the more genius one has looked over the past few months.
The US dollar may weaken further over the longer term, but in the interim the risk of an oversold U dollar bounce now looms:
“Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.
This unravelling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. 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.”

After last week's big sell off in equities, and big bounce in the VIX(volatility index), a few rebound days would be the norm this week. But our technical work on the U dollar suggests an interim dollar rebound is increasingly probable. Investors should beware of the price risk the dollar carry trade has brought back into world markets.

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