It was only last month ago that we warned of the risks of potential unwinding of carry trades, and now Turkey has shown us what the impact on cross-currency imbalances can be. As a reminder, as economic growth and interest rate policies continue to diverge in the US vs eurozone (and Japan) yield differentials have widened, encouraging unhedged carry trades, particularly as the dollar has rallied against the euro for most of this year. This process in itself can further strengthen the dollar. But ultimately when the trade gets too crowded and/or the yield differential narrows it can all reverse. Or if you’re borrowing in a non-domestic currency and your currency weakens there can also be problems.
We’ve often been asked what the catalyst for the next crisis could be. To this we point out that catalysts are not obvious, even with hindsight. e.g. the 1999/2000 tech bubble didn’t really have one at all, other than valuations became stretched. We find it more instructive to look at how much stress there is in the financial system. We see particularly large stresses in the current account surplus of Germany/Netherlands and consequent deficits elsewhere, as well as high government debt/GDP ratios in many countries, which under a stress scenario could become unsustainable. This latter group, maybe surprisingly, includes the US according to the IMF. Maybe someone should tell Donald Trump.