The doomsday scenario (again) from Roubini

Road to Riches: A new doomsday scenario - KC Star

As your holiday shopping spree morphs into a wrapping frenzy, wrap your brain around this obscure economic nugget – the carry trade.

Chances are, you’ll hear more and more about the carry trade in the new year.

Already it’s fueling serious economic debate.
Economist Nouriel Roubini, a.k.a. Dr. Doom, blames the carry trade for what he predicts will become the mother of all bubbles. Others cite the carry trade as a brewing speculative problem, though with less dramatic consequences.

Here’s how some believe the carry trade is inflating a new bubble.

It starts with super low interest rates in the United States.

Our Federal Reserve drove short-term rates to historically low levels as one of several moves to halt last winter’s financial crisis and reverse the now two-year-old recession. Cheap money helps businesses finance expansions, consumers buy cars, and the U. S. Treasury finance stimulus packages.

But cheap money is cheap for everyone, including the carry-trade speculator.
In a simple carry trade, an investor borrows dollars cheaply and converts them into another currency, let’s say euros, and then uses the euros to buy securities that earn higher interest rates.

The investor profits by earning higher rates in Europe while paying lower rates in the United States.

But that’s not the carry trade threat Roubini warns about. To get to his scenario, we have to ratchet up the game with a currency side bet, and leverage it more with a high-stakes payoff.

The side bet is that the U.S. dollar will itself get cheaper before the investor has to pay back the bucks he borrowed. As that happens, the investor needs fewer euros to pay back the U.S. dollar loan, turning some of his euros into increased profit.

This is exactly how it has played out since mid-February as the dollar has fallen sharply against other currencies.

By Roubini’s math, the declining value of the dollar more than offsets the low interest cost on the dollar loan. He argues that the carry trade funded with borrowed dollars generates it own substantial profit simply from the dollar’s weakness, even if the investments bought with euros don’t earn a thing.

But we’re still not to Roubini’s disruptive scenario.

To get there, the investor uses his euros to invest in a high-return asset.
Think gold, whose price has climbed 27 percent since mid-February, or Asian real estate stocks that have jumped 70 percent, or even U.S. stocks that have risen 30 percent higher since then.

Here’s Roubini’s hammer.

He basically argues that the dollar carry trade isn’t simply benefiting from these rapidly rising markets, it’s causing them. Not by itself, but certainly in a significant way by funneling buyers their way.

All’s well until the big payoffs stop, perhaps because U.S. interest rates begin to climb or the U.S. dollar strengthens.

If a Roubini-style carry trade bubble has inflated by then, we can expect a stampede to rival any Friday-after-Thanksgiving door-buster rush. These crowds, however, will be clamoring to get out of their carry-trade funded positions in gold, Asian real estate and Dow Jones stocks.

Pop! The bubble bursts, and we all know how that goes.

Certainly not everyone buys Roubini’s doomsday scenario. And some serious economists dismiss the idea.
But it’s an uncomforting thought that threatens to linger well past the holidays.

Road to Riches appears in Dollars & Sense every other week. To reach Mark Davis, call 816-234-4372 or send e-mail to mdavis@kcstar.com.