Kimball Corson's  Instablog

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.