Prior to the bust, the Japanese yen was the favoured currency behind the so-called “carry trade.” Traders would borrow a cheap currency, buy risky assets, and then profit. It was basically that easy.
But the cheap yen has been replaced by the cheap dollar, so that everything priced in dollars has soared like crazy.
And just as the dollar is showing some signs of life, and just as the market shows an inlking of a breakdown, here comes Roubini warning about the coming bust of the carry trade.
FT: 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.
What’s scary about the carry trade this time is that it’s the world’s underlying, reserve currency that’s the source of the trade. The yen is a big deal, but it’s nothing like the dollar. If it reverses violently: watch out.
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