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November 2, 2009

Today's Bubble Post -- Fed Blowing Up HUGE Asset Bubble

-- by Dave Johnson

This is an important read, to understand the bug crash that is building up: Mother of all carry trades faces an inevitable bust,

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply , while government bond yields have gently increased but stayed low and stable.

[. . .] 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.

. . . 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.


Essentially the Fed is giving out free money, while forcing the dollar down. (A lower dollar is a good thing for American manufacturing.) At the same time they are guaranteeing a price for assets. They are forcing the financial sector to make huge profits.

The problem is that the financial sector is doing this with huge leverage again, borrowing on top of borrowing, which is the kind of massive risk that led to last year's crash. It is inevitable that the bubble will pop, and maybe soon. At the same time, they have guaranteed that the too-bigger-to-fail banks will be bailed out.

So get ready for another round.

Posted by Dave Johnson at November 2, 2009 7:37 AM


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