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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  1. gian

    I believe RGE acknowledges that the fed and ecb may start draining excess liquidity in the later half of 2010. However, the boj will certainly not follow their steps, which means that yen is likely to become a new funding currency.

  2. xav

    They can keep rates low for a very long time.

    Remember in the past they raised rates when they had to. There was a significant amount of inflation as the “money” created was making its way into the economy. They had to, otherwise we would have ended like the Weimar Republic.

    We are ages from that.

  3. Yves Smith Post author


    I believe you are missing the point of the argument. Operationally, they can keep rates low. However, what is the object of this exercise? To boost asset markets to avoid recapitalizing the banking system and to goose the stock market to build confidence. Investors are becoming increasingly distrustful of the moves governments are taking and are increasingly looking to commodities as a store of value. It won’t take much of an increase in commodity prices to put the economy firmly in reverse gear.

    1. fladem

      You write that investors are becoming increasingly distrustful of government actions. I guess I don’t see that given the stock market increases – so I must be missing something (and I am not being sarcastic here)

      What your post misses with respect to Roubini is how wrong he has been on the stock market since March. I vividly remember him saying that the rally was a “dead cat bounce” with the S&P at 800, and my guess is some of his advice is driven by the knowledge that he missed a significant advance. His current advice allows him to keep his general view in tact while simultaneously advising people to invest in the bubble and then get out before it bursts.

      1. Skippy

        I don’t see that given the stock market increases – so I must be missing something…

        See: HFT algos, discount window, primary dealers, interest rate et al….vs volume…

  4. emca

    The arguments for and against a carry trade parallel the yeas and nays of oil, and from your last paragraph, more than mirrors them. Browsing the Oil Drum earlier is an eduction on the saga of an peak oil (PO) its ramifications and time line. One would assume given eventual shortage of that commodity, one could speculate a corresponding pricing edge. Unfortunately the site also posts an article reviewing new Iraqi targets for ramping up crude extraction and exportation. The article is Here
    Now given that the Iraqi target is ambitious (to say the least is an understatement) the author speculates that if (again a big _if_) such an events where to unfolded, peak oil, or when we fall off the supply plateau, could be delayed for as long as a decade. Any bets on any appreciation of price do to shortages would fall against reinvigorate supply. If nothing else, one will see an increasing set of unpredictable variables, with demand fluctuations and prices wild and woolly reflecting upturns and down of global economics and whatever other demand constraints will come aboard.

    I’m not sure Roubini is that far off, but his prognosis is extremely fragile, and like oil, is based on actions of a government: 1.can do or can’t do, 2.might do or might not do, 3.knows or doesn’t know, it perceives the world, 5.what its priorities are and 6.who’s to be screwed this go-around (Of course if we limit to variable number 6, then the uncertainties will vanish).

    Also of note, the latest bid by multi-nationals on drilling rights for Iraqi oil, despite wide and unfailing corruption of their government, appears to have been a transparent process. We know who bid, the terms and amounts of the awards (the Iraqis, one Hussein al-Shahristani, are evidently tough negotiators and are showing an indifferent, one could say – ungrateful, attitude toward U.S. generosity in unilateral intervention). Whether this openness holds or not remains to be seen. What is instructive is that we have some idea of the moves being made, their tact and expectations, rather than operations wound in mists of secrecy and conjecture, as seems the norm in our home-spun democracy.

    I might be getting off the subject a little, but suffice it to say, I don’t have much disagreement with the uncertainty involved in a carry trade strategy.

  5. curlydan

    I’ll put my mind money on Roubini. I think Gross is talking about what should happen given the funding needs of our govt in the next year, but what should happen and what actually (and often magically) happens are different things. Rates and treasury yields stay low, and a-holes make a killing.

  6. Richard Kline

    I seriously doubt that any move of substance is made in 2010 to drain liquidity or end Federal market guarantees. Yes, some would like to do that, but Federal ‘queasing’ IS the economy, plus the churn off it for big players. The banks aren’t fixed. The housing market continues to implode. The impact of CRE failures haven’t really entered the system let alone worked through it. Show me a strategy for the Guvmint to get out and I’ll believe it’s possible. Not that it is going to happen, but that it’s possible. Those receiving government largesse are effectively dictating policy; the government hand is a puppet hand. And those getting largesse show no inclination to let go of it (since they’re dead if they do).

    Bill Gross is a very smart man. I will say that I’ve completely lost confidence in the _substance_ of his remarks, having watched his pattern now over the last two years. He talks his book and for effect. What he _really_ believes I seriously doubt that he discloses. I’m not saying his remarks are disingenuous, but to me that are for effect not content.

  7. Timeserver

    I’m not impressed by Gross’s reasoning. He’s probably talking his book again…

    The huge amount of money printing by the US government so far doesn’t make up for the destruction of private credit, which is why we continue to see little signs of inflation. Obviously, huge deficits can’t go on forever, but they can most definitely go on for several more years without causing inflation. Basically, the government can and must create new money to replace lost private wealth, in order to avoid deflation. Because stock and credit markets have recovered since March 2009, the loss of private wealth is less than then. But I think some of this boom in asset values will eventually be reversed, necessitating another round of money printing to keep the system from falling into deflation.

    Personally, I’ve got most of my money in stocks because I’m waiting for the one year capital gains holding period to elapse, which will be the end of February through early march in my case. As soon as that happens, I’m lightening my stock load considerably, in favor of intermediate-term high-quality bonds. dollar-denominated too, since I have little worries about a dollar collapse. The weak dollar versus the euro is already hurting European exports and they are highly unlikely to tolerate a still lower dollar. (Incidentally, a little known fact is that Dubai was a major source of German exports for the past few years. Now that has pretty much dried up. Germany should show signs of this lost business sometime later this year.)

    As far as commodities, these can’t go up for the reason Yves noted. Namely, a hike in commodities prices acts as a tax hike, given that the commodities exporters never spend all of their revenues but rather retain a small part as foreign reserves. But tax hikes without equal-sized spending hikes are deflationary. Given that our economy is still teetering on the brink of deflation, any rise in commodities prices will bring on a double-dip recession and require another round of stimulus.

    As for the Roubini idea of following the trend which is our friend until we jump off before the bend at the end, I again agree with Yves. This is a recipe for disaster. My feeling is the party will end sometime this summer. Stocks are overpriced and the only reason people are buying them is the fear of being left behind (continued underperformance of benchmarks is a firing offense for money managers). Once the selling starts, it could easily turn into a wild stampede for the exits. If a collapse of the US market was accompanied by a collapse in China, then watch out below.

  8. Samuel Morales Jr.

    I suspect the Fed Fund Rate to stay near zero, or zero for at least 10 years. It has no exit strategy for the time being. If you want to gamble, get into the dollar carry-trade. Inflation is being created, but the effects of it (high consumer prices) can take years (at least 2 years) to manifest. By then it would be too late anyways. Remember, this is Bernanke that is operating, he insists he can control inflation even by printing money. He thinks he can control liquidity from hitting the real economy with his tricks even with 0 zero interest rate. We shall see, but I don’t have much faith into a mortal man like Bernanke.

  9. Jefferson

    As Gross points out, the Fed has made it clear the current round of QE will end in March. The credibility of the Fed with the debt markets requires that Ben make an effort to comply with the previously established level of QE.

    While circumstances may result in the Fed eventually being forced to launch QE2, disastrous events in the financial markets will likely precede the undertaking of any additional measures.

    Gross apparently believes and I agree 100 percent that the Fed’s lack of continued participation in the Treasury and GSE market will result in USD interest rates rising precipitously. Of course, such an outcome would immediately cause a dramatic unwinding of the carry trade particularly to the extent it is dependent on the USD as the funding currency. I see nothing in congruent with the fact that PIMCO’s $100 billion+ bond portfolio has been positioned accordingly.

    It boggles the mind that Roubini would suggest that his subscribers try to load up on the carry trade whether the funding currency is the USD or the Yen. When the rubber band snaps this time around, the proverbial rush to the exits will be something to behold.

    By the way exactly how much money does Roubini manage over at NYU?

    And what was the investment return of subscribers who followed Roubini’s suggestions last year?

  10. Jefferson

    The only real bone of contention I have with Gross’ analysis of the current situation in the financial markets is his recommendation to load up on German Bunds. He does not address whatsoever the current fiscal crisis brewing in the Club Med region and the potential fallout that a potential default in Greece, et. al. might have on the Euro. Perhaps he believes that at least in the Euro region any fiscal crises originating in the PIIGS would result in a flight to safety into the Bund by Euro based investors. Of course, if the Germans then chose to go ahead and finance a bailout of one of the PIIGS then presumably a rise in Bund rates would soon follow.

  11. Brick

    Both arguments have merit and I think some have missed the point about where Gross thinks the carry trade will occur. I don’t think he is suggesting that the money will go into risky emerging markets equities and commodities but it will go into the longer term safe debt of countries like Australia and Canada. Why would you hold longer term US or UK treasury debt when you can hold high paying Australian or Norwegian debt which will possibly benefit from currency fluctuations. Money flows into commodity rich countries treasury debt could well drive up their currencies, driving up the price of commodities. The question then is who would do this and what would be the evidence for it. My guess is that it is the banks who need to hold more risk free assets while maintaining available liquidity. This I think would show up in a steepening yield curve while banks shift from long dated maturity US treasuries into shorter maturity US treasuries and longer dated maturity commodity rich country treasury debt.The result will be bumper profits for banks as they play the yield curve while the real economy suffers from increased credit costs and rising prices (Stagflation). When price indexes start to show commodity inflation Ben will be forced to support MBS again and raise the target rate long before he wants to. My view is that the carry trade is in safe treasury debt not risky equities and commodities and the differentials in central bank target rates will force the hand of the central banks in the US and UK.

    1. simpleflyer

      I think you need to consider the relative size of Canadian debt, let alone Norway’s. i just don’t think anyone is going to get rich lending money to the Cdn government with borrowed US. dollars, the spreads between our government debt and yours are so thin, you can’t even cover the cost of the currency exchange. Also, given the importance of Canadian exports to the U.S., B of Can’s Carney is going to raise interest rates rather reluctantly (although he may have to, housing prices here have recovered so fast, there are now worries about a bubble.)

  12. Graham

    Roubini backing the carry trade? Perhaps he is morphing into a money manager. Since March, Roubini has been an abject failure in his predictions as he misread or misunderstood the impact of the gargantuan injections of liquidity. Gross played it brilliantly. Roubini appears to be trying to time the exit strategy as is Gross. They are both plugged into the White House but I think Gross grasps the reality of the situation as someone is playing with real money.

  13. Ruth Harris

    Canada’s total national debt is about $500 Billion (in CDN dollars). I’d guess Australia is about the same. How much money would be chasing that debt, if investors want to move out of USD?

  14. Moopheus

    Bill Gross talks his book, but throughout the crisis, he seems to have more often than not gotten what he wants from the Fed. If he makes it clear that it’s to his advantage for rates to move one way or the other, I’m not sure I would bet against it happening.

  15. bob goodwin

    Gross talks his book, and roubini has no book.

    That being said, as long as there is a geithner and falling M3, there will be QE.

  16. dearieme

    “may make for a very real outcome in 2010 and beyond”: I don’t know whether that is talking his book or not, since it seems to be pretentious fluff.

  17. Felix López

    No private investor o company can carry trade the dollar in a meaningfull way today (that is, it can not be leveraged). We are not in a low interest world but in a HIGH interest scenary (ask for a loan) Only banks have the privilege of low interest rates and could do the carry for its own account. That will missmacht the books on currencies for the bank. This is very serious matter of irresponsability, so -knowing the banks- probably they are the doing it. This is easy to check by the regulators, but again, who nows?

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