DUBAI DEBT WOES MAY MARK END OF RISK TRADE / BARRON´S ( VERY HIGHLY RECOMMENDED READING )

FRIDAY, NOVEMBER 27, 2009

UP AND DOWN WALL STREET

Dubai Debt Woes May Mark End of Risk Trade

By RANDALL W. FORSYTH

Liquidity-driven gains are vulnerable as rising risk awareness forces reversal of positions.

THE IMPACT OF THE UPHEAVALS in Dubai extends far beyond the middle eastern emirate. Indeed, it may be the beginning of the end of the global risk trade, if it isn't over already.

While U.S. markets were closed Thursday for Thanksgiving, bourses abroad plunged after the government of Dubai asked to extend payments on the massive debt taken on by Dubai World, the government's flagship corporate entity.

More importantly, the currency markets have shown unmistakable symptoms of a flight from risk. While the dollar edged higher against most currencies, the yen soared.

In addition, the ongoing rally in Treasury securities pulled yields down still further, with the key two-year note quoted at a new low of just 0.66% in Asia Friday morning as investors sought shelter from the latest credit storm.

A year ago, the U.S. and Japanese currencies also moved sharply higher as global investors unwound risk positions, which involved repaying borrowings denominated in those currencies -- effectively covering a short position. That process appears to be underway again as the yen soared to the highest level since 1995 -- less than 85 to the dollar in Tokyo Friday morning.

Meantime, gold and commodities -- other key beneficiaries of the risk trade -- also were sharply lower. Among the hardest hit have been commodity-related bourses and shares. For instance, Australian mining giant BHP Billiton was down over 3% early Friday.

If the debt standstill by the emirate were the only sign of rising risk in global markets it could be overlooked. But it is no aberration.

Earlier this week, the Chinese government reportedly sought to have its banks to raise additional capital, a move that effectively reins in credit for China, the main engine that is pulling the global economy out of recession.

Even sovereign debt securities -- the bunker to which skittish investors traditionally hide -- have come under pressure.

The cost to insure Japanese government bonds has jumped in recent weeks amidst growing concerns that nation's debt burden had become insurmountable.

Similarly, Greek government bond prices plunged and their yields soared in reaction to that nation's growing economic crisis. In theory, as a member of the eurozone, Greece's government debt should trade near parity to that of Germany, Europe's largest economy. But the risk premium on Greece's government debt has widened since riots broke out over in Athens in late summer over the worsening decline in the Greek economy.

Meanwhile, the U.S. economy has shown that the recovery from the worst recession since 1930s does not conform to the simplistic notion of "the bigger the drop, the bigger the pop."

Third quarter gross domestic growth was downgraded to a 2.8% annual rate from the original estimate of 3.5% as consumption was less than first thought. Meanwhile, the jump in sales of new and existing homes clearly can be traced to buyers looking to take advantage of an $8,000 tax credit originally slated to expire Nov. 30 until extended and expanded by Congress. That indicates how truly anemic the housing market is, even with the Federal Reserve's plan to pump $1.25 trillion into mortgage-backed securities, a scheme that has lowered fixed-rate home loans into the bargain basement under 5%. Similarly, absent the cash-for-clunkers boondoggle, automobile sales remain depressed.

All of which can be traced to the inescapable truth that unemployment officially is 10.2% and 17.5% when those who can't find full-time work or have stopped looking are counted. Meantime, despite the Fed's massive easing of monetary policy, credit continues to tighten, as its most recent survey of lending officers showed.

But with liquidity shut off from the real economy, it has flowed into asset markets and into the so-called carry trade -- borrowing at the near-zero interest rate resulting from the Fed's federal-funds target of 0-0.25% to invest in anything else that provides a higher return. And with the dollar losing value steadily against foreign currencies, it has literally paid to borrow to invest in anything else, with the key exception of the Japanese yen. Since it became cheaper to borrow in dollars than yen, greenbacks have become the key funding currency for carry trades.

The cracks have not been all papered over from the output from government printing presses in the U.S. and elsewhere. While that liquidity did stanch the bleeding that followed last year's crisis, it also helped levitate U.S. equity markets nearly 60% from their lows. And the riskier the asset, the greater the gains, from small-cap stocks to junk bonds to emerging markets.

But those trillions have not cured the underlying debt deflation at the root of the economic crisis. In past cycles, the reliquefication by central banks could be counted on to pump-prime the economy. Borrowing and lending would resume after having been restrained by tight monetary policy, and a new cycle would start.

After the bursting of the debt bubble, the process isn't working. It may have stoked a speculative binge in commodities, currencies and risky securities, but the real economy continues to labor.

As it does, grandiose projects such as Dubai World collapse under the weight of their huge debts. Risk, previously suppressed successfully by policy actions, begins to increase.

That, in turn, forces the curtailment of risk positions, from hedge funds to Wall Street proprietary trading desks. Hedging costs rise, forcing further reductions of positions in a vicious circle. As year-end approaches, the willingness to hold risk positions is reduced still further, exacerbating the process.

Even with the U.S. on holiday, this train of events is proceeding. Stocks shed upwards of 3% Thursday and continued to fall Friday in Asia. The yen and dollar are higher while short-term Treasury yields are setting new lows.

It appears the end game for this market phase has begun.

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