Monday, November 2, 2009

Pick Your Poison

After reading Nouriel Roubini's latest article in the FT I feel less certain about what the Fed should be doing going forward. On one hand I see figures like the one below from the IMF's World Economic Outlook (p. 32) that point to excess global capacity and the ongoing threat of global deflation (the bad kind) and come to same conclusion as Scott Sumner:
If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase. That would help everyone.
In short, the Fed should use its monetary superpower status to ensure there is ample global liquidity and in so doing stabilize global nominal spending.

On the other hand, Nouriel Roubini claims the current Fed policies in conjunction with a large dollar carry trade is creating a new set of asset bubbles:
Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals... So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fueling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time.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 fall in the US dollar leads to massive capital gains on short dollar positions.

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.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

Roubini is not optimistic about what this means for the future:
[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.
So what is the bigger threat: global deflation or asset bubbles driven by Fed policy and "the mother of all carry trades"? Tim Lee via Buttonwood also sees potential problems to the unwinding of this dollar carry trade. I hope there is another way out for the Fed.


  1. Roubini writes, "Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals..."

    Have they? I am not sure. The DJIA, for example, fell from 14,000. Thus, while they have appreciated quickly in recent months, they are still down almost 30%.

    And if you believe Sumner, monetary policy cannot be to blame.

  2. "global deflation or more asset bubbles from the Fed" ? Hayek evocatively called this catching a "tiger by the tail". His solution was radical monetary reform. It may yet come to that?

  3. Josh, along the same lines the one critique I had of the Roubini article was that it was short on evidence. However, that was probably more the result of article space constraints since a quick look at the trend this year in commodityand stock prices year show growth. The tough question is whether the growth is justified by fundamentals or not.

  4. This problem seems another instance of the problem the Fed has faced in the past couple of cycles, and seems doomed to face as long as our financial arrangements are what they are. The Fed can only address one set of circumstances with rate policy. Circumstances in the domestic real economy are likely to require a different rate stance than circumstances in asset markets. In the past, the Fed chose to address asset markets as merely a leading indicator of conditions in the real economy (at least, while asset prices were rising, or not falling too fast). We have learned to our sorrow that asset markets can be so decisive in determining real economic outcomes that asset markets need to be targeted for their own sake, but that required abandoning the real economy to whatever wind may blow.

    The Fed needs new tools. We are about to legislate new financial regulations, and I see little evidence that the Fed wants real power to limit bubbles, or that Congress wants any agency to have such powers.

  5. Anon says: "The Fed needs new tools" Good grief! How many new tools do they need? We have a veritable alphabet soup of new lending programs and guarantees, undreamed of in the philosophy of the pre-crisis Fed. Indeed, one should I think realize that over the last decade, monetary policy making morphed into a tripartite structure of the FRB, FHLMC and FNMA. It seems pretty clear that the Fed moved policy "off-balance sheet" onto the GSEs in order to stave off the perceived threat of deflationary collapse post-2001.
    Advocating new tools for the Fed is about as wrong-headed an assessment of how we got where we are and where we need to go as I can imagine. "Problems faced by the Fed" indeed!! Where the hell do you think these problems originated? (Pardon my French)