Carry trade is the name of the strategy of going short in a low-interest rate currency such as the Japanese Yen or the U.S. dollar while going long in a high-interest rate currency such as the New Zealand dollar.

Commentary about the carry trade has reached a high pitch. Professor Roubini asserts that it will “unwind” soon, sending stocks, commodities, and risky bonds lower and causing a financial crisis that would dwarf that of September 2008. He describes the current U.S. dollar carry trade as the “mother of all carry trades”, and claims that the dollar will stop falling in value soon. This would then cause an unwinding of the carry-trade and declines in the commodities and stock markets. His article is here:

http://www.ft.com/cms/s/0/9a5b3216-c70b-11de-bb6f-00144feab49a.html

I partly agree with Professor Roubini. I believe the carry trade is fueling some of the demand for stocks, commodities, and risky bonds. I also agree that the dollar will stabilize at some point and that then funds will flow out of stocks, commodities, and risky bonds. However, I believe that excess funds in search of high yields are another reason for the financial market rally (since March of this year). These were funds that had been sidelined during the financial crises that started in September 2008.

The macroeconomic impact of a drop in the stock market would mainly hit consumption. I discuss in another blog posted yesterday that quarter 4 consumption is likely to drop relative to quarter 3 mostly due to the lack of a Cash-for-Clunkers program in quarter 4. If the stock market dropped in quarter 4, consumption could be driven down yet farther from the Wealth effect.