Roubini Sounds the Alarm (Again)

Nouriel Roubini is back at it, delivering the latest battle call in his war against complacent optimism. This time, Dr Doom is concerned about "the mother of all carry trades", where investors are borrowing dollars at negative interest rates (due to low nominal rates, and an ever-depreciating dollar), and investing them in anything that is risky and from emerging markets. Hence the disparity between real economic growth and financial market growth.

This new carry trade is quite dangerous, as it is based on the assumption that the dollar will continue to plunge and emerging market investments will continue to pay off handsomely. Should it unwind, due to a rising dollar or emerging market crisis, markets would become dangerously volatile, which would then hamper the real economy (sound familiar?):

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fueling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades.

The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

In effect, it has become one big common trade- you short the dollar to buy any (Roubini's emphasis) global risky assets.

Considering the fact that Roubini has built a brand around being a permanent naysayer (one critic dubbed him a "false prophet"), should we be paying attention to his warnings? Or is he simply crying wolf?

Although I tend to be skeptical of Roubini's hysterics, I can't help agreeing with his current prognosis. As I discussed last week, capital flows to emerging markets have taken on a life of their own. Just like in the summer of 2008, where the dollar's decline appeared to be in perpetuity and the BRICs seemed unstoppable, the current market seems to be making a similar one-way bet.

Everything seems to be moving a bit too fast, with investor confidence a bit too high.

(Photo Credit: Wall St. Cheat Sheet)

Comments

[damienhaas:]

In 2007, A lot of people laugh at Roubini for his "not so popular" predication. So I would not so hasty in judging his call now.

Nov 03 07:56 AM

[doubleguns:]

I like Roubini. He can't change the direction or outcome of the market but only a dipstick would not listen to what he has to say. If the market continues on this course this is one possible outcome. I like knowing what to look for and why.

It helps me chart my course through troubled waters should things get stormy as he predicts. There are however MANY storms to watch for in these markets.

Nov 03 07:57 AM

[bartpr:]

what if all these shorts had to cover. we have aother financial crisis on our hands. they have to sell emerging mkts and commodities to cover. this is too much for me, retired and down to 20%

Nov 03 08:12 AM

[Tony Petroski:]

The message here is that even the boy who cries wolf gets it once in a while.

Still, if this is doom, we could do worse. Are there prophets of doom minus 3?

Nov 03 08:47 AM

[Adonis:]

I am a bull, but I enjoy reading what Roubini ahs to say because it provides a different viewpoint. I read this article and when you compare it to what Bill Gross says in his monthly outlook, the next 6 months are dark.

So how do you benefit from this? Do you hedge a little and go long the dollar, or slowly start to short the commodities? This 'bubble' (Roubini's word not mine) could last for awhile, and there are good profits to gain. But the burst will be fast and loud.

Nov 03 09:18 AM

[Solon:]

Roubini is always correct, just move on from there.
The dollar can drop lower and help the US debt repayment concern. It can approach the neighborhood of zero without any real negative effect. There is no real reason why it can not stabilize at zero plus, say, epsilon; and the 'bubble' can achieve equilibrium as well.
So much for the Protestant ethic.

Nov 03 10:40 AM

[Mad Hedge F...:]

bdr This is how you trade this market. Buy the dips on any pull back in any asset, keep a tight stop loss, and run like Hell if it get’s triggered. No doubling up or leaning in. There is only one problem with this strategy. This is how the entire rest of the world is trading! So after the first couple of mouse clicks to the downside, the markets will seize up, as they did last year. Anyone with a position larger than the change under your living room sofa cushions won’t be able to get out. Portfolio managers will helplessly watch as their positions get marked down with no trade. The world has been borrowing dollars at zero and buying anything and everything, and the time to pay the piper is fast approaching. Dr. Nouriel Roubini, the Turkish economics professor at New York University whose recent negativity has brought him guru like status, made some interesting points yesterday. The Fed is keeping rates low to hasten a recovery before the next election, but Wall Street is jumping on the gravy train and avariciously coining it, creating a new bubble worse than the last one. When the inevitable synchronous global crash happens, it will make last year’s affair look like a walk in the park. There will be no place to hide. If we learned anything last year, it’s that the global capital markets have become Roach Motels. You can check in, but you can’t check out.

Nov 03 11:10 AM

[sdfsdf:]

I like Roubini a lot. He has the guts to say what every one else will not tell us the common investor. I first heard him in 2007 on bloomberg and as a result moved my 401K to cash best thing I ever did.

Nov 03 01:04 PM

[Ad Orientem:]

Roubini is partly correct. The recent movements in markets, especially the overseas markets is a consequence of a veritable ocean of liquidity that is looking for a place to go. Where I think his reasoning is weak is in his concern for the possibility of a sudden strengthening of the dollar.

Although markets don't move in straight lines, as the last week or so proved with a short dollar rally, long term trends do exist that are dictated by underlying fundamentals. The fundamentals for the dollar remain extremely poor. In order for the dollar to see a sustainable rally I believe we would require at least one or possibly both of the following to occur.

1. Congress and the administration get serious about debt control and start cutting spending deeply and raising taxes sharply.

2. The FED begins aggressively raising interest rates and starts soaking up at least some of the massive amount of liquidity out there.

Absent at least one of the above I see no long term sustainable rally in the dollar's near or intermediate future. Worse still, is that we may reach a point where this ocean of liquidity starts to move outside of the financial markets where it has thus far been confined, and we see a tsunami of money enter into the broader economy. The consequences of that could be a very sharp rise in domestic inflation on top of the dollar's weakness in the FOREX.

For now I continue to follow an investment strategy of extreme diversification largely adhering to the late Harry Brownes' Permanent Portfolio thesis. (See my insta blog)

Nov 03 01:52 PM

[Donald Ingram:]

Roubini's warning is complete common sense. Only 3% of traders are bullish on the USD, this is very attractive to a contrarian. If anyone has researched the many pundits recently with any diligence, they will have realized by now that the USD may very well perform a strong upside rally. I'm with Mish on his arguments for this very thing to happen. I smell profit in the making by going long USD. Those in the carry trade who are massively short the USD will receive exactly what Roubini has touched on. A Wall Street cleaning. It remains to be seen if this will result in a global shock wave that the global financial system will have trouble absorbing. Very interesting times indeed!

Nov 03 02:10 PM

[Spartacuss:]

Where, oh where is that monkey in the woodpile?

Without doubt there has been an easy money carry trade influence of major proportions creating yet another bubble. I have long held that the real danger is not in the bubbles themselves, but in how rapidly they occur. While I don't have the stats to show, I think it is fair to say that relatively, each new bubble occurs in about half the time of the previous one and thus we reach a point eventually where we cannot create another new bubble anymore as the cost becomes unbearable. I.e., the fear factor.

I posit that we are there and this next POP is going to be a doozy, a free fall brought about by the big banks going from long to short in a heart beat...us little guys will be eaten alive. However, I am betting on a flat market until after the elections, but then too the waters are getting a little roiled and if the fear index is as high as I think it is, all bets are off.

To be safe, is to sit in cash or precious metals and perhaps both.

Nov 03 03:42 PM

[Ad Orientem:]

Donald,
I am curious what you think will shore up the dollar and cause it to rally in the long term. I don't see any fundamentals that would generate a sustainable rally right now. Could you provide some insight into your support for the dollar beyond that everyone thinks its a looser?

It is worth noting that sometimes when everyone is telling you to get out of the house because it's on fire, it might be because the house really is on fire.


On Nov 03 02:10 PM Donald Ingram wrote:

> Roubini's warning is complete common sense. Only 3% of traders are
> bullish on the USD, this is very attractive to a contrarian. If anyone
> has researched the many pundits recently with any diligence, they
> will have realized by now that the USD may very well perform a strong
> upside rally. I'm with Mish on his arguments for this very thing
> to happen. I smell profit in the making by going long USD. Those
> in the carry trade who are massively short the USD will receive exactly
> what Roubini has touched on. A Wall Street cleaning. It remains to
> be seen if this will result in a global shock wave that the global
> financial system will have trouble absorbing. Very interesting times
> indeed!

Nov 03 06:10 PM

[Donald Ingram:]

As soon as the global markets roll over into the next part of the double dip (soon) there will be another flight to safety by scared capital. Even though there has been a loss of confidence in the USD - where else to go? As the old saying goes "any port in a storm"! This is where the USDs rally will come from and it will be a short lived, temporary rally, just high enough to shake out all the shorts and provide some profit for the nimble longs.
> Donald,
> I am curious what you think will shore up the dollar and cause it
> to rally in the long term. I don't see any fundamentals that would
> generate a sustainable rally right now. Could you provide some insight
> into your support for the dollar beyond that everyone thinks its
> a looser?
>
> It is worth noting that sometimes when everyone is telling you to
> get out of the house because it's on fire, it might be because the
> house really is on fire.

Nov 03 07:15 PM

[Ad Orientem:]

Donald,
OK. I see that you are looking for a short term trade. From that perspective there may indeed be a dollar rally. Long term fundamentals however do not support any sustainable rally in the dollar. Indeed I don't see any real floor for the dollar right now.

I don't do a lot of short term investing. It's too high risk in the current environment and I am by nature a conservative investor who favors a long term approach based on economic trends and fundamentals while staying highly diversified.

If you choose to make a bet on a short term dollar rally that's fine (although as I said its high risk). But I would keep your finger close to the sell button at all times (or your broker on speed dial), because no dollar rally is going to last absent major action in Washington.

From the long term perspective the dollar is done. You can stick a fork in it.

On Nov 03 07:15 PM Donald Ingram wrote:

> As soon as the global markets roll over into the next part of the
> double dip (soon) there will be another flight to safety by scared
> capital. Even though there has been a loss of confidence in the USD
> - where else to go? As the old saying goes "any port in a storm"!
> This is where the USDs rally will come from and it will be a short
> lived, temporary rally, just high enough to shake out all the shorts
> and provide some profit for the nimble longs.

Nov 04 12:46 PM