An explosive trade

In a little over a month something interesting and perhaps significant has happened in currency and commodities markets. The US dollar is off its lows and gold is off its highs.

Since late November the US dollar has risen just over 5 per cent against its key trading partners while gold has slipped a little over 3 per cent. That's unlikely to be a coincidence.

The gold price has been one of the bigger beneficiaries of the financial crisis, rising about 50 per cent over the past year as fearful investors sought security and protection against an imploding US dollar. So strong had been gold's resurgence that it has ignited a fierce debate about whether or not it had moved into bubble territory.

That is part of a larger discussion about whether the massive infusions of liquidity into banking systems by central banks, and particularly the negative real official rate settings established in the US, were spawning a series of new asset price bubbles as investors pursued so-called 'carry trades' funded by effectively costless borrowings in the US.

Gold has been the focus of recent debates but the broader argument has been whether the excess liquidity in the developed world is driving up assets prices – equities and commodities in particular – as investors/speculators deploy cash and cheap debt to pursue yield.

There is a particular concern that speculative funds are pouring into emerging markets and setting the scenes for nasty implosions in those economies in future.

That is a real worry for the Chinese authorities, whose own dramatic response to the financial crisis – massive stimulus packages and relaxed lending standards, has already heightened fears of a domestic property market bubble and raised concerns over the state of its banking system. A doubling in the Shanghai Property Index over the course of 2009 illustrates how hot the sector has been.

The equity markets of the developing countries have also soared over the course of the year – even in the context of the sizeable rebound in developed markets – as flows of funds into emerging market equity funds reached record levels. China, Brazil, India and Russia's equity markets have benefited from the strength of their economies relative to the US and Europe.

The inflows to China are also reportedly motivated by an expectation that the Chinese government will have to bow to the external pressures to allow the yuan to appreciate.

The prospect of a domestic property bubble and flows of hot money into its markets is already worrying China, with Premier Wen Jiabao saying this week that the government would use taxes and interest rates to "stabilise" the property markets and keep inflation at "reasonable" levels. He also said China would "absolutely not yield" to the pressure to allow the yuan to appreciate.

The currency issue is causing some tensions in the relationship between China and the US, which has been slapping duties on imports of Chinese steel, among other products, alleging dumping. There are signs of rising protectionism emerging in the US which would add another dangerous element to the already fragile settings of the global economy.

A stronger US dollar while the US economy remains anaemic isn't going to help defuse those tensions. Nor is it helpful to the broader stability of the global financial system.

If there are myriad massive US dollar-funded carry trades out there channelling funds from or via the US into emerging markets and commodities (and chasing relatively high but relatively low-risk real returns in currencies like the Australian dollar) the one obvious threat to those trades would be a sharp rise in the US dollar. That threat would be even more severe if hedge funds have shorted the US dollar to amplify their returns.

A sudden rush for the exit from these carry trades would trigger implosions in equity markets and commodities around the globe and almost inevitably create another round of major losses for investors and institutions.

With the US unlikely to raise official rates or halt its unconventional interventions in the US markets to ensure there is cheap and ample liquidity for US banks and other financial institutions and stimulus for a very weak economy, that doesn't appear to be an immediate threat.

If the global economy and financial system remain stable through the first part of 2010, however, central banks will have to start shifting their focus from stimulus to inflation and begin planning the withdrawal of the emergency measures.

At that point there will be a risk that the hot money will pre-emptively flow out of emerging markets and commodities and generate new sources of volatility and instability.