Monday, November 23, 2009

A new asset bubble burst and the rise of the USD

The negative cost of dollars led to the formation of asset bubbles in everything from equities to commodities etc. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

Behind the synchronized rally are near-zero US interest rates and a cheaper dollar. 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 decline in the US dollar has lead to massive capital gains on short dollar positions.

To sum up: traders have been borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Each investor who has played this risky game so far looks like a genius, even though they have just been riding a huge bubble financed by the large negative cost of borrowing, as the total returns have been in the 50-70 per cent range since March.

In effect, it has become one big common trade. The dollar was shorted to buy any global risky assets, only one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate as was seen in previous reversals, such as the yen-funded carry trade. The leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as leveraged long risk asset positions across all asset classes funded by dollar shorts trigger a co-ordinated collapse of all the risky assets equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative and the risk of a dollar movement’s reversal will induce many to cover their shorts. Secondly, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Thirdly, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later, and fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion today would trigger a dollar rally at a time when huge short dollar positions have to be closed.

The longer and larger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall. One might credit the Fed for not being so stupid and blind to the “monster bubble.” The problem however lies with their allocation of higher priorities than the formation of bubbles; executive compensation of US banks ranks much higher on their agenda? Our expectation is the Fed will try to break the bubbles. This will probably take the form of leaning on China to put its WTO money where its mouth is to fix some of the global trade imbalance. You might even say the global bubbles are as much China’s fault as the US'.

Our continued warnings afford our subscribers the fullest opportunity to prepare themselves for the forthcoming crash.

Geir Solem
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