Re-Bubbling the Economy

NYU economist Nouriel Roubini, nicknamed Dr. Doom for predicting the last asset bubble, explains why "the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments" is creating the next asset bubble:

Let us sum up: traders are 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. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

A "carry trade" is when traders borrow money at a low interest rate in one currency (now the US dollar), then buy assets in another currency that rewards investors with a higher interest rate. That allows an investor to buy risky assets with potentially big returns because they're borrowing dollars so cheaply.   Carry traders look like geniuses...until interest rates change, as they will eventually. Then traders rush to the exits.

...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 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.

Scary.

Of course Roubini was early in predicting the last asset bubble.  He cried “doom” for many years. Maybe he’s wrong now. But I fear he’s right. That is the danger when governments try engineer an economy.