Tears before bedtime?

Most parents know the situation. The children are playing happily in the evening. Indeed they are rather too lively. There is a danger that, at any moment, the mood might flip and there will be tears before bedtime.

The current financial markets bear many similarities to this happy but unstable family evening. As the economist Nouriel Roubini wrote this week:

• "Since March, there has been a massive rally in all sorts of risky assets — equities, oil, energy and commodity prices... At the same time the dollar has weakened sharply."

Roubini's view is that this asset rally is another bubble that will burst at some point. Roubini is worth listening to. He was one of the few economists to see that the world economy would crash as a result of the US housing and asset bubbles.

Roubini's latest argument is a fascinating one. In effect, he says, investors have been borrowing dollars at heavily negative interest rates and piling this money into risky assets.

The negative dollar interest rates have come about because investors are "shorting" dollars — that is, selling dollars they have borrowed at low nominal interest rates to buy higher-earning assets, a practice known as "carry trades".

This practice has helped to push down the dollar's value, which reduces the amount investors have to pay back, when it is measured in other assets.

Roubini argues that this situation cannot continue. At some point, the dollar will rise again — for example, if fear returns to the markets — and/or the authorities will start raising interest rates. Investors will then have to unwind their investments in risky assets to pay back their dollar borrowings.

The bubble will burst, says Roubini. Indeed, he argues that:

• "...the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall."

It is hard to imagine that Roubini has got it wrong. Investors, like parents, may hope that the good mood won't end in tears. But unlike many investors, parents know that hope alone is not enough.