Dollar, Capital Flows, and Roubini! |
What do I have in common with Nouriel Roubini? We’re about the same age, and we were both born in European countries, although at opposite extremes of the Continent. What’s different? Mr. Roubini thrives on “busts” while I prefer a balanced approach and focus on “booms” and “busts.” We also differ on conclusions. I recall Mr. Roubini’s piece in the Financial Times on November 1, 2009, titled “Mother of all carry trades faces an inevitable bust,” in which he laid out his opinion on the eventual deleveraging of the Dollar shorts and how it would wreak havoc in all markets of all stripes.
But one day this bubble will burst, leading to the biggest coordinated 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 coordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.
Psychological speaking, I find expressions such as “biggest bust” demoralizing and, worse yet, such mindsets tend to cloud one’s judgment as the anticipation of the event builds. The same is true about “biggest boom." Where I disagree with Mr. Roubini is on the generic approach that states “a coordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments” because, as far as I can tell, every asset is a risk and I’m not certain what non-risky assets he had in mind. In his view, and assuming that I’m interpreting his writing correctly, everything will be dumped for cash. Not in a million years! Furthermore, collapses are never coordinated.
In his opinion, the carry-trade strategy was due to backfire, and 12 months later the strategy did come short of expectations and somewhat fulfilled the prophecy, although a collapse didn’t quite ensue as reported by Bloomberg on January 4, 2011.
Currency traders that seek profits by borrowing in nations with low interest rates to fund purchases in countries with higher yields are losing more money than at any time in at least a decade.
The strategy lost 2.5 percent in 2010 as the dollar — a favorite for financing the trades because of record low U.S. rates — appreciated, according to an index compiled by UBS AG, the world’s second-largest foreign-exchange trader. That’s more than the 0.98 percent drop in 2008 when the collapse of Lehman Brothers Holdings Inc. caused credit markets to freeze and the worst performance for so-called carry trades since at least 1999 when UBS began releasing yearly figures.
Falling demand for carry trades may help the greenback extend a rally that drove IntercontinentalExchange Inc.’s U.S. Dollar Index up 4.5 percent from its 12-month low on Nov. 4. Gains in manufacturing and retail sales are leading investors to buy the dollar, rather than sell it to fund other investments.
The difficulty always exists when we try to visualize macro global economics from our living room, especially when all we know is that Fried Rice is the basis for Chinese cuisine, or that Outback Steakhouse is an imported replica of Australia’s standard fare. They aren’t! In the early 90s, I worked with a friend on a project in China and he had to travel there for 32 days. He was dismayed that the typical dishes that he was accustomed to weren’t available — and lost a lot of weight.
It’s far easier to relate to our own assets and how our capital is allocated, and to see economics through a domestic prism. In addition, much is written about domestic economics that if one is astute enough (I’m still working on it) to follow commentary and read between the lines, a somewhat accurate national economic picture can be drawn which is usually different from official accounts, or the opinion of Wall Street instructed “experts.” Enter the international factors, and we start to get lost due to politics, culture, language, cuisine, currencies, and other idiosyncrasies. But in truth, when it comes to money, every global citizen seeks the same outcome: profit. How and why they do what they do, can often escape the most street smart thinkers among us. Then there’s the so called “smart money,” as opposed to you and I, the “dumb money.”
"Generally, we want to follow the Smart Money traders – we want to bet on a market rally when they are confident of rising prices, and we want to be short (or in cash) when they are expecting a market decline. We also call this measure the ‘Buy Confidence’ indicator – it tells us how much confidence we should have in buying the market."
—Sentiment Trader
Somewhat true about “Smart Money traders” but not always, because they’re juts as fallible as the rest of us and don’t all live in our back yard. Where we may see a loss, others may still see a profit due to foreign exchange rates. Furthermore, the best of Hedge Funds have not being doing too well as of late — and they’re as “smart” as money can get. Although the S&P ended 2010 up 13%, many hedge funds were behind, with the industry average pegged at about 4%, according to hedge fund research.
Common wisdom holds that a market’s fundamentals, and (the perception of) potential future earnings, within a positive economic background, drives value. It is correct to a certain degree, but sometimes capital flows to Equities for several reasons, and an economically strong foundation is not a prerequisite. Sometimes the options are all bad, and capital will flow to the best of the worst.
A healthy habit, when confronted with conflicting opinions, is to take a step back and to look for the smallest common denominator — just like we did in school when simplifying fractions. Remember how 1/3 became far more palatable than 264/792 (I’m sure you didn’t know that the latter was 1/3, and neither did I until I did the math). And 264/792, not 1/3, is what I used to get from my advisors so their expensive expertise seemed justified. What we need is economics for the layman/laywoman. Now grab a cup of coffee, and think about the globe in simple terms, taking it step by step. USA is first.
- Everyone knows that the USA is the export destination of choice (and necessity) for most world output.
- Real Estate looks pretty dim, and is not likely to attract much money.
- Bonds are overdone, and with the government needing to borrow more, rates will rise.
Now let’s think Europe:
- Stocks hinge on exports and anemic domestic consumption is currently plagued by austerity plans. Enough said!
- Real Estate is a mirror image of the USA because they tend to mimic everything Americans do.
- Bonds? Debt? Lots of it and rates will rise because private investors are not going to lend at low rates when risk is high.
Asia is next, and one can think of South America in the same terms:
- Once again, stocks are the mercy of exports, because internal consumption cannot absorb production.
- Real Estate not likely to flourish when China is overheating (who knows why and a new article that deals exclusively with this enigma is in order), Japan has been burnt, and the others don’t matter.
- Bonds? They also have debt (and lots of it), and must compete in the international arena for cash. Thus rates are going higher.
As we all know, and despite the claims of BRICs driving growth and all that nonsense, until the USA’s economy is out of the hole, nobody will get back on their feet. So which one did I miss? US Equities! And that is where capital will be flowing to, because it’s the best of the worst and will be the first to get back on their feet. At the same time, the Dollar will rise in tandem with the Dow (DIA), S&P 500 (SPY), and Nasdaq 100 (QQQQ) — which is counterintuitive. At some point in the future, maybe 1 to 3 years, it will bust, just like it always does, and then we start all over again. So does a Dollar short deleverage crash the world we live in? Somewhere, but not everywhere!
P.S. If you do no want to embark into Futures trading, you can invest in the Dollar in two flavors: PowerShares DB USD Bull (UUP) or PowerShares DB USD Bear (UDN).
