The huge rally in risky assets since March of this year has been interpreted as a sign that monetary and fiscal stimulus packages are working – at least for the financial markets – and economies are on the mend again.

The risky assets concerned include shares, commodities, high yield bonds, and virtually anything going in emerging market assets (shares, bonds, currencies).

The most powerful force behind this rally is the US Federal Reserve, according to leading US economic commentator Nouriel Roubini.

However, far from thinking that the Fed is doing a great job holding everything together and building confidence in financial markets again, Mr Roubini is worried that the central bank has engineered another fragile asset bubble waiting to burst.

The Fed copped a lot of blame for the asset bubble that preceded the global financial crisis.

It was argued that back then that the central bank kept US interest rates too low for too long.

Worse, it fell asleep at the wheel when it should have realised that cheap money was leading to impending financial market collapse as more and more risky bets were taken, most infamously in punting on American sub-prime mortgage lending.

The jargon from those times was the “search for yield” to describe how investors embraced high risk because cash returns were so scanty.

The situation was aggravated by leverage, where it paid to borrow money at low interest rates and use it to buy assets of high risk.

One leverage phenomenon of the period was the “carry trade”, which involved borrowing a very low interest rate currency like the Swiss franc or Japanese yen, and using the funds raised to buy assets denominated in another currency that had higher interest rate returns.

The difference between the low interest rate on the borrowed currency and the high interest rate on the purchased assets – plus any capital gains thrown in besides – was money for jam for the carry trader.

There were contingent effects from carry trading: witness the steady rise of the kiwi dollar despite determined attempts by the Reserve Bank of New Zealand to weaken its exchange rates.

A significant contributor to our currency’s stubborn escalation against our national economic interest was insatiable demand from carry traders chasing our then high interest rates by world standards.

The one teensy problem with the carry trade back then – as now – was that the conversion rate between the borrowed and the purchased currencies could move against the carry trader with a vengeance.

If the borrowed currency rose in value versus the purchased currency, any carry trade profits could start to dwindle fast as time loomed to repay the loan.

If the conversion rate moved adversely enough, profits shrank to breakeven, and then withered to outright loss on the deal.

Carry traders can find themselves smashed by big enough currency conversion movements against their leveraged position.

All a thing of the past, one might suppose, in this new era of tight credit, deleveraging, and prudent attitudes towards risk in financial markets that the global financial crisis has ushered in.

Not so, objects Mr Roubini.

He claims that the Fed by its zero interest rate, money-printing policies has financed the “mother of all carry trades” that kicked in since March of this year, explaining why financial markets have taken off like a rocket.

Worse, the Fed reaffirmed in its November monetary policy statement out of the Federal Open Markets Committee (FOMC) that zero interest rates and money printing would continue for some time to come.

On interest rates, the FOMC said: “The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”

So the greenback will stay cheap, with many commentators picking that the Fed won’t move up the federal funds cash interest rate until December 2010.

On money printing: “To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Federal Reserve will purchase a total of $US1.25 trillion of agency mortgage-backed securities and about $US175 billion of agency debt.”

The agencies involved are the notorious likes of US government-sponsored residential mortgage lenders Freddie Mac and Fannie Mae.

The Fed spared commentator speculation on how long this spending spree funded by printed money would continue by stating further that it “anticipates that these transactions will be executed by the end of the first quarter of 2010.”

Mr Roubini argues that this largesse has financed a huge and wobbling asset bubble because of the profits it can rack up for carry traders who borrow in US dollars to buy risky foreign assets.

“The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time,” he wrote in a recent article entitled Mother of all Carry Trades Faces an Inevitable Bust.

“Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.”

“Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade.”

“Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.”

So there we have it: according to Mr Roubini, it is back to the future in borrowing to the hilt in a cheap currency – in this case the greenback – to buy risky assets that could pack up at any time.

Thus the mystery of the big rally since March explained, if Mr Roubini is correct.

Even more dangerous is that strong correlations (close similarities in trend) have converged across the price behaviours of different risky asset classes – shares, bonds, commodities, currencies, emerging markets – so that the diversification value of spreading funds across them is lost.

One of the currencies caught up in the carry trade correlation convergence has been the New Zealand dollar, soaring in value despite a new round of attempts by the RBNZ to talk it down.

If one of these highly correlated asset classes goes belly up, they all go the same way at the same time, as occurred after the Lehman Brothers’ bankruptcy in September 2008.

Mr Roubini is convinced that the Fed’s generously funded asset bubble will burst, so it is not a question of if, but when.

The trigger will be mass onset of risk aversion associated with panic flight to the greenback as a safe haven.

“As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short [ie., borrowed and spent on foreign assets] dollar positions will have to be closed,” said Mr Roubini.

“This unravelling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while.”

“But 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.”

Just like old times at the Fed, it seems.

And if this bust occurs, what will the Fed do: keep interest rates at zero, print more cash, and buy more dud assets for years to come perhaps?

Now that sounds like a plan in the making.