Carry trade bubble will burst, so be prepared

DESPITE his notorious doomsaying, everybody does sit up and pay attention to Professor Nouriel Roubini&rsquo;s views on the market. And earlier this week, he argued that the mother of all carry trades &ndash; borrowing dollars and using the proceeds to invest in countries with higher interest rates &ndash; faces an inevitable bust, with problems for all asset classes. <br /><br />With the Fed reducing US interest rates to near zero, carry traders have been enthusiastically selling dollars in order to fund purchases of assets such as equities and commodities, which have rallied more strongly and more sustainably than was thought possible nine months ago.<br /><br />But this trade has really taken off over the past month or so. Not only are investors taking advantage of the Fed&rsquo;s cheap money, they are also benefiting from the depreciation in the dollar. The falling value of the dollar across the board means that investors are borrowing at the equivalent of very negative interest rates &ndash; as much as a negative 10-20 per cent annualised in Roubini&rsquo;s view, enhancing the gains on their short dollar positions. <br /><br />This has encouraged investors to sell dollars and buy up risky assets. Normally this would set alarm bells ringing &ndash; with everything being driven by the carry trade and therefore all asset classes going up at the same time, investors should realise the world is facing a bubble in the making. <br /><br />With the US Federal Reserve buying a wide range of risky assets at home, this bubble in all assets is also inflating in the US. The result is that all assets across the world appear safer than they really are and this is further encouraging investors.<br /><br />In the short-term this will only serve to enhance the desirability of the carry trade strategy as the dollar continues to depreciate and the rally in risky assets continues. However, like any overblown bubble this will not last forever and at some point the depreciation in the dollar will come to an end and we will see a reversal. <br /><br />Roubini points to four factors that could see the bubble burst. Firstly, the dollar cannot fall to zero and will stabilise &ndash; at this point a reversal in the dollar&rsquo;s fortunes would force investors to cover their dollar shorts by exiting positions in risky assets. Suddenly, assets will start to collapse and their true riskiness will become evident again.<br /><br />Secondly, the Fed cannot continue to buy risky assets for ever and this will reveal the true riskiness of these assets to investors. Thirdly, if the Fed intimates that it will start tightening interest rates sooner rather than later then this could also see the dollar start to strengthen. And you can&rsquo;t discount the possibility of a geopolitical shock. The dollar and US Treasuries are perceived as safe-havens and investors will flood back into the dollar. Forex traders should be aware that all these might happen and try to anticipate them as much as possible.