Roubini v. Gross on Outlook for 2010

Roubini v. Gross on Outlook for 2010


I saw this item on RGE Monitor (Nouriel Roubini’s blog/economic analysis website) and was gobsmacked:

Greetings from RGE!

A couple months ago, in a widely read FT op-ed, Nouriel Roubini warned that the “mother of all carry trades,” one funded in U.S. dollar denominated debt, could pump up asset bubbles around the world…

When uncovered interest rate parities break, investors can borrow money in a low interest rate currency (like the U.S. dollar), then loan it out again in a currency with higher interest rates. The “carry,” or the return from this investment, equals the difference in yield between the funding currency instrument and the destination currency instrument. “Positive carry” occurs when the interest rate received surpasses the interest rate paid to fund the investment. “Negative carry” is the opposite. Because the carry from a single trade is often small, carry trades are usually conducted in large volumes through leverage or are held for relatively long periods of time (months or years) so that the small amount of rollover interest collected on a daily basis can add up to a worthwhile amount of passive income.

As both new RGE reports highlight, we expect the carry trade to heat up as 2010 progresses, as policymakers hold rates at zero or low levels in many advanced economies, while inflation leads to further rate hikes in emerging market and commodity-driven economies. We encourage clients to examine these papers for more details on hot carry trade destinations for 201

Yves here. Ahem, this sounds like a pretty aggressive call to follow a global momentum trade fuelled by cheap liquidity. Roubini was on the opposite side of this call last time. He now argues for riding the bubble and (presumably) plans to people when to get out. The problem is that a lot of investors in 2007 knew the markets were overheated, yet were confident they could get out in time. And we know how that movie ended. Chuck Prince couldn’t get to the exit fast enough when the music stopped. Why should this time be any different?

Reader Gary sent a copy of Bill Gross’ January newsletter, which is not yet on line. Gross also sees the markets as liquidity driven, and reaches a conclusion that differs from RGE Monitor’s:

….the shifting of private investment dollars to more fiscally responsible government bond markets may make for a very real outcome in 2010 and beyond. Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this “juice” was being squeezed into financial markets. If so, then most “carry” trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their “sugar daddy.” There’s no tellin’ where the money went? Not exactly, but it’s left a suspicious trail. Market returns may not be “so fine” in 2010. [boldface his]

The way to square the circle is that RGE believes the generous liquidity support will continue:

But we expect carry trades to resume in 2010 as policy rates stay at or near zero in the major economies and inflation leads to further EM and commodity-country rate hikes….We expect the Fed to stay on hold throughout 2010 at this writing, but the pricing of Fed hikes will remain volatile, driven by the data flow.

Gross, by contrast argues that if the powers that be stick to their plans (note the if), risk-seeking trades will suffer.

Now there is a complicating factor in all this. Remember the commodities bubble of 2008. Commodities markets are not that deep, relative to the financial markets. And they are a favorite place to try to hedge against inflation, and lotsa liquidity makes investors worry about inflation, even if it has not shown up in the data or consumer/business expectations. But commodity price increases blow back fast to the real economy in very disruptive ways, particularly via energy prices. Jim Hamilton has argued, for instance, that the oil price increases of early 2008 were what pushed overextended US borrowers over the edge. Frail economies similarly cannot take too much in the way of energy input price rises. So even if the RGE crowd is right, that the Fed will lose its nerve and not withdraw liquidity support, we could still see the bubble implode. As Keynes pointed out, all it takes is a change in investor liquidity preferences, meaning investor attitudes towards risk, to precipitate a contraction. And that can occur independent of the price and amount of funding on offer.
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