Roubini On The Dollar Carry Reversal, And Why He Is Only Half Way There

Nouriel has a great op-ed in the FT, discussing the imminent reversal of the dollar carry trade, a topic Zero Hedge has been harping on for quite some time: not because we believe that in the long run America will stabilize its economy (on the contrary), but because in a globalized economy (yes, a sad side effect of $1.4 quadrillion in derivatives is the fungibility of declining asset leverage) economies are relative, not absolute concepts. While our biggest pet peeve has to do with the lack of contrarian thought in whatever the groupthink trade de jour is (when everyone is on the same side of the boat, it always inevitably capsizes), Nouriel is similarly unimpressed with what he sees is doomed to end badly for so many institutional and retail traders who are part of the herd mentality. Never one to mince words, Roubini's conclusion is scary:

[O]ne 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 closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

His reasons for the inevitable unwind are as follows:

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 riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, 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. 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 such 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 would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

In principle, we couldn't agree more with Dr. Doom. In practice, we think Roubini is only half way there, implying that the swift reversal will be even uglier (and swifter) than even Nouriel thinks possible. By that, we refer to our analysis of BIS estimates of dollar-denominated duration funding mismatches. Observant readers will recall that this number was estimated as large as $6.5 trillion shortly before Lehman. While the number (hopefully) has declined in the past year, the primary reason why the Fed took on over half a trillion in FX liquidity swaps with foreign banks had precisely to do with providing a near-term dollar-based funding source. And this was the point we made in our previous piece: while it is true that on one hand the global economic system is now faced with a potential massive dollar short squeeze, the fundamental maturity mismatch problems are still endemic to the international system. Simply said, dollar unwind risks are based on both a short squeeze as well as another unsecured/FX swap market implosion, most likely in some form of vicious circle.

Curiously, none other than the NY Fed came out with a research piece, subsequent to Zero Hedge publishing its thoughts, entitled "The Global Financial Crisis and Offshore Dollar Markets" in which it essentially recapped our salient points regarding the inception (but not the consequences) of a predominantly dollar-denominated asset holding philosophy.

 

The paper does a good job at quantifying the impact on the dollar basis (a very interesting topic in its own right), yet stops short of providing an estimate of what could happen, should the biggest potential squeeze trade go haywire again. As Satan says in the Devil's Advocate, "well consider the source, son," this is not very surprising.

In conclusion: we agree with Roubini on the imminent threat of the squeeze counterplay, yet we wish to underscore the danger of the speed of the eventual unwind: the coupling of the carry unwind as major financial and non-financial players seek suddenly rare dollars, coupled with what will undoubtedly be another FX swap implosion, will make the Volkswagen melt up in which the company quadrupled its market cap to over $300 billion in a matter of hours, seem like shroomed up slow motion. When that happens not all the printing presses in the world will make an iota of difference as approximately $50 trillion in assets all try to exit single file through the side door of the burning Bernanke cinema where Moral Hazard, the movie plays 24/7.