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The danger of new bubbles
11/21/09
05:49:50 pm, by RT, 339 words 
Categories: Investment, Central Banks/Government, Banks/Investment Banks
FT: Germany warns US on market bubbles, Nov. 20, 2009
German Finance Minister Wolfgang Schäuble's worries worries about the huge volumes of carry trades:
"He said: “More likely today is a scenario in which excess liquidity globally creates a new [sort of] asset market bubble.”
He added: “That low interest rate currencies such as the US dollar are increasingly being used as a basis for currency carry trades should give pause for thought. If there was a sudden reversal in this business, markets would be threatened with enormous turbulence, including in foreign exchange markets.”"
He is in good company:
Dr. Nouriel Roubini: "What is fuelling the massive asset price rally across the board? "One important factor is the weakness of the US dollar, driven by the mother of all carry trades. Traders are borrowing at negative 20% 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."
While the riskiness of portfolio investments has effectively increased due to the near perfect correlation in asset prices, the VIX and risk premiums in general have been receding thanks to the Fed's (an other central banks') QE operations.
Moreover, the dollar weakness exacerbates the global monetary easing in a self-reinforcing manner: "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."
What makes the carry trade unravel? First, the dollar cannot go to zero and at some point the cost of borrowing in dollars stabilizes. Second, the Fed cannot suppress volatility forever. Third, the Fed may tighten sooner than expected. Fourth, political risk may spark flight to safety. "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.""(11/01/09)
1 comment
•Andrew Hunt Economics (via FT/Morph 366): Looking back, a similar asset price "melt-up" happened in the aftermath of the S&L crisis in the early 1990s when Greenspan kept interest rates low for a long period of time for banks to earn their way out of their losses. Banks took advantage loading up on Treasuries and funding a global carry trade especially with emerging markets. However, as the Fed started to tighten in 1994, the meltdoown from the carry trade exit were substantial especially for emerging markets (e.g. Tequila crisis in Mexico). Moreover, all those banks loading up on subsidized Treasuries and MBS might get caught on the wrong side of things when interest rates rise. (10/30/09)
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