Financing the World Asset Bubble and Its Impact on the Dollar

From several comments to articles about the worldwide asset price bubble, and from some of those articles, too, I observe considerable confusion about how the asset price bubble is being financed and how it impacts the dollar. Many think that, inasmuch as virtually no one in the U.S. can borrow at reasonable rates, the carry trade and therefore the asset bubble cannot exist. Others believe that a large carry trade in dollars necessarily means there is downward pressure on the dollar. Neither is true. I explain.

As part of its quantitative easing and low interest rates policies, the Fed has targeted its purchase of $1.25 Trillion of agency mortgage-backed securities for the period from January 1, 2009, through the end of the first quarter of 2010. It is on track. Over the same time interval, the Fed is buying $175 billion of other U.S. agency debt. In roughly the first three quarter of 2009 or through October of 2009, the Fed also bought $300 billion of U.S. Treasuries, clearly increasing the money supply by at least that amount. So does the purchase of agency debt if it is backed and authorized by the federal government and new dollars are used to buy it.

These are the sources of dollars for not only the carry trade, which by definition requires borrowing dollars or leveraging, but also for dollars that can simply be exported to seek higher earnings abroad by those who own them and previously held Treasuries or agency debt.

By themselves, these exports of dollars would seriously depress the dollar. However, there is a countervailing consideration. When the foreign central banks receive dollars for their sales of local currency to invest, they typically turn around and buy Treasuries with those dollars which neutralizes the downward pressure on the dollar. The net impact on the dollar from this source is essentially zero if the flow in each direction is the same. But there is the rub.

Although the U.S. is the biggest player by far, other G-20 nations also have low interest rate policies and are also using quantitative easing. For example, the E.U. is likewise financing the worldwide asset bubble and in the same way. But when Euros are transferred abroad for higher returns to buy local currencies, the foreign central banks may or may not purchase all Eurobonds. They might purchase some Treasuries as well. Or they might buy more Treasuries than Eurobonds. Factor in all the nations using some variation of low interest rates and quantitative easing and you can see there is considerable slippage regarding not only what happens to the dollar, but also to the Euro, as well as to the other currencies. Of course, other economic factors likewise affect these various exchange rates.

These currency flows can make it very hard on foreign central banks in high return countries. Brazil, for example, is using its exchange controls to block many such capital transfers seeking higher returns. It does not want asset prices to bubble up and returns drop in its country. Australia recently created a ruckus when it decided to raise its interest rates, but unlike many nations Australia has resisted quantitative easing and now faces a solid upturn in its economy.

Leveraging and the carry trade are not the only means by which the worldwide asset bubble is being financed. The impact on the dollar from that financing is likewise variable. The basic source of the moneys used to push up world asset prices and lower their returns is the governments of the world using longer term low interest rate policies and quantitative easing. Disclosure: none

Comments

[Davewmart:]

Check out the Bank of England's take on asset bubbles, currencies and so on:
www.bankofengland.co.u...

Nov 11 04:28 AM

[User 353732:]

There is a bubble in free credit financed US financial markets and in debt financed real estate in Asia but most hard assets are not in bubble.

A rising dollar denominated asset price is not sign of a bubble but a resetting of exchange rates between the debasing dollar and those asset classes that cannot be degraded by the US and UK Govts or readily manipulated by Wall St.
When measured in real prices or against real stores of value hard assets such as oil, iron ore, copper,timber, agricultural land and monetary metals such as gold, silver and now platinum are by no means in a bubble: there has been no disconnect between fundamental value and real price.

Money illusion and bubbles are not at all the same thing.

Viewing the world thru the prism of the dollar leads to money illusion. Viewing the world thru the prism of enduring stores of value and intrinsic worth provides greater clarity: it is not real assets that are inflating unsustainably(bubbling) but the dollar that is shrinking rapidly. Relative motion is not a bubble.

Nov 11 06:49 AM

[Dave Wrixon:]

I have great difficulty trying to reconcile the jargon being applied to global markets. We hear about asset bubbles but almost in the same breath Americans talk about less risk adverse investments as opposed to safe haven investments in the US. Which is it? You cannot have it all ways. You seem to want to treat the rest of the World as though it is infected with the plague to underpin otherwise untenable fiscal and monetary policies in your own economy. Well, I can tell you it cuts no ice here.

Nov 11 08:46 AM

[Kimball Corson:]

I should clarify the worldwide asset price bubble developing is mostly in regard to financial assets, especially now in foreign countries with higher returns that don't have low interest rate policies or quantitative easing.

Foreign physical assets, especially commodities, are less vulnerable because they require storage or maintenance and management, difficult to do from afar, and the financial returns on them often come solely by price increases or differences and the demand for them derives mostly from their value in use (except those historically used as stores of value). Rarely do U.S. citizens buy a ton of foreign iron ore as a store of value, but some do buy gold in the U.S. and store it.

The prices of foreign financial assets are being driven up by the means I describe in parts of the world lacking our policies, not only in dollar terms, but also in terms of the local currencies. In a sense we are exporting our financial asset price inflation. Brazil, among others, does not want that. Returns are driven down with rising financial asset prices in the local curency.

Nov 11 08:51 AM

[Kimball Corson:]

Dave Wrixon. There are foreign financial asset bubbles developing by the means I describe. The notion of "less risk adverse investments as opposed to safe haven investments in the US" mostly centers around U.S. government debt vs. stocks and bonds in both the U.S. and abroad. Right now, stocks in some foreign countries are less risky than those in the U.S. Most who are really risk adverse simply buy U.S. Treasuries. Too, risk is reflected in the returns of financial assets, as you suggest, but we need to distinguish between assets with higher returns that are risky and foreign assets whose prices have not yet been driven up by the asset price inflation mechanism I describe, which seeks to equalize returns for comparable risk.

Nov 11 09:19 AM