The Carry Trade

The carry trade involves borrowing at a low interest rate and investing (or lending) at a higher return. Lately, big money investors have been engaged in the carry trade by borrowing US$ at very low rates and investing in Australian bonds, emerging markets, and commodities, as well as plain old stocks and bonds. Traders are essentially betting on a falling US dollar, and they've been right so far.

The problem with this type of carry trade is that it is creating a bubble. A bubble occurs when investors borrow against an overpriced asset to buy more of that asset. (See Galbraith's A Short History of Financial Euphoria in the amazon panel on the right for an interesting treatise on bubbles). When interest rates or the US dollar go up, or the market price of the asset starts to fall, investors have to sell what they can to avoid defaulting on their loans. This leads to panic selling and falling asset prices.

So you can expect a fall in emerging markets, Oz bonds, and commodities, and probably everything else. This could happen as soon as mid to late 2010 if the Fed raises rates then. It could happen earlier if the US dollar rises.

Interestingly a big doom and gloomer based on the carry trade is Roubini, who predicted the securitized debt meltdown (see here).