One of the largest components of the worldwide asset bubble that hit its top in 2007 was the carry trade. A carry trade is when money is borrowed in a low yielding currency in order to buy assets in another currency that will be high yielding. Preferably the borrowed currency should be from a strong industrial country and the target assets should be in a high growth (hence emerging) market. The former rule is because the carry trade artificially keeps the borrowed currency lower than it should be while high growth is easier in emerging markets.

The risks of the carry trade are as follows:

• The currency target of the carry trade may be driven too low, causing destabilization when its central bank raises rates.
• The emerging market target may go bust for some reason, leading to the asset values (in terms of the carry trade currency) to fall. These trades are highly leveraged and so a small decrease will wipe out most players.
• The currency target country may suddenly grow faster than expected, again leading to the raising of rates.
• Too many people will perform the same trade, leading to an unstable point where it seems like everything is alright, but an event that goes wrong causes massive unwind as everyone scrambles to undo their trades.

From 2002-2007 the carry trade currency of choice was the Yen. This is because Japan was trying its hardest to avoid deflation, a result of its 1980s asset bubble that they never allowed to resolve itself, and kept the interest rate extremely low. You could take a loan out in the Yen for around 1.5-2% and invest it in an emerging market at 10%+, a huge spread that seemed “safe.” In this case emerging markets even included Australia and New Zealand, as they had high yielding currencies and strong commodity based growth. However the trade got too crowded and when the financial crisis hit everyone fled to the safety of the large currencies (Yen, Dollar, Euro) and out of emerging markets. This led to the most violent currency whipsaw in history.

This chart is of the Yen to the Australian Dollar, an incredible sight for a currency cross of two industrial economies:

The emerging world currencies fared even worse and have still not recovered.

Nouriel Roubini, aka Dr. Doom, was one of the most prominent people to predict each stage of the financial crisis thus far. Until recently, he had been extremely bullish (for him) and said that most likely we had avoided systemic collapse but were just needing to deal with years of very low growth. His latest column reverses this course dramatically. He argues that the largest carry trade in history has taken root with the dollar as the borrowed currency and Fed policy is allowing it to grow to monstrous proportions.

The dynamics in this trade are highly negative. They are keeping the dollar suppressed, which is raising import prices which is putting pressure on emerging markets which will eventually cause their growth to stall and people to come back to the safety of industrialized world assets. To make matters worse, a lot of people doing this are from the industrialized countries, so it’s tying up their capital into risky markets instead of the shaky home market, meaning a bust will wipe out both sides.

Roubini has been right about the dynamics thus far and there is little reason to view his analysis in error presently. In fact it is a variation on what I have been calling the “worst case scenario” that very few people have believed could happen. I have been saying that most people expect either large deflation or large inflation, but to me the most likely and worst outcome would be domestic deflation but import inflation. While I didn’t identify the carry trade as the exact mechanism, I did realize that it could force the dollar low enough that the Fed will have to raise interest rates in order to stop a commodity super bubble at a time when the country was near zero growth (either that or the huge increase in import prices leads to another leg down for consumer spending and mass job loss).

In my mind the primary question is whether this dynamic can continue to hold up long enough for the problems to occur or whether the next downturn is only a few months away and the reversal of funds will be rather “moderate” compared to what is possible. In either case, unless we break up the banks and take other major action to restore balance to the domestic economy, we are only in the second stage of the crisis and haven’t seen nothin yet.