A few weeks ago I agreed with Nouriel Roubini's notion that a dollar carry trade is forming, which faces an inevitable bust. Heiko Hesse from the IMF has tested Roubini's thesis, and finds evidence that the dollar carry trade most likely exists. The proof is in the reverse correlation between the dollar's value and major asset prices, such as oil:
The U.S. dollar has seen an increased negative co-movement with major asset price classes in recent months (here the MSCI Emerging Market index, the EMBI+ bond spread, S&P 500 as well as oil prices). For example, the negative co-movement between the U.S. dollar and oil prices is almost at its highest since the beginning of 2006 with -0.5. Jen (2009) recently provided a number of reasons why the correlation between the dollar and crude oil prices has been so negative.
While the increased co-movement of the U.S. dollar with a range of risky assets does not provide any evidence for the dollar carry trade per se, the fact that the correlations have almost reached the highest magnitude since the beginning of the sample period in 2006 for (several fundamental) asset classes suggest that a dollar depreciation has gone hand in hand with a sharp appreciation of higher-yielding emerging market asset classes. This is consistent with a story whereby the unwinding of safe-haven flows has significantly led to the rebound of risky asset classes, and the U.S. dollar, bolstered by U.S. quantitative easing and low interest rates, could have increasingly served as a funding currency.
Roubini warns that a flight from risk is likely to trigger the unwinding of this carry trade.
How do the recent events in Dubai figure into this prognosis? I see two possible interpretations.
An optimist could look at the Dubai case and argue that a globally integrated emerging market has experienced a crisis, yet nothing has happened to the dollar. Thus, fears of an unwinding of the dollar carry trade are exaggerated.
Or, one could argue that Dubai is the first domino to fall. Because of Dubai's woes, investors may become more wary of sovereign risk, and grow cautious about Ukraine, Greece or Ireland.
Roubini's prophesy may yet become filled.
(Image from iStockphoto)
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