Baring Asset Management fears that the currency carry trade favoured by Japanese and investors in other low-interest countries could be a bubble that is about to burst.

According to Alan Wilde, director of fixed income and currency at BaringsÆ institutional headquarters in London, there could be liquidity problems on the horizon, if interest rates rise and domestic investors begin to favour their local currencies.

The market hinted at such concerns last week, with the pressure felt by two favoured currencies used to facilitate the carry-trade, the Australian and New Zealand dollars.

ôThere has been a big increase in lending to finance these short carry-trade positions,ö Wilde explains. ôThese positions are enlarged but if three-to-six month interest rates move higher in the countries using the trade, this could cause a reversal in transactions.ö

The problem, he adds, starts with the fact that volatility in the fixed interest market is at a historically low level.

ôDespite the [high] oil price, commodities have not been as volatile as before relative to their historical situation,ö he says. ôLiquidity on global financial markets has supported the carry trade but having to close out a carry-trade position could cause volatility.

ôCredit spreads have already fallen to very low levels. Banks in the United States have started to drop their lending to hedge funds, which could start them off on a course of closing out carry-trade positions.ö

As far as geographic asset allocation is concerned Baring is continuing a long-held bet on economic slowdown in the US.

ôWe have bought into the US slowdown,ö Wilde says. ôAnd we did so long before its advent was apparent. We have felt that the Federal Reserve was in danger of over-tightening and because core inflation may tick higher it is premature to talk about cuts.ö

The final days of Alan GreenspanÆs highly regarded time at the helm of the US Fed could, Wilde argues, have masked some of the problems brewing in the US economy.

ôGreenspan used an emergency policy action of cutting interest rates to keep US economic growth above trend,ö he explains. ôThis may have masked problems in the building up of a current-account deficit through the demand for overseas goods. Core inflation may be much higher than reported so the new Fed chairman, Ben Bernanke, could move to slow down growth below trend.

ôA growth rate of 2% is still positive but it may not be deemed palatable by the market. This would be good for real bond returns and longer duration bets.ö

Baring has bought into the long end of the market as well as mortgage-backed securities, while is underweight in corporate credit, given the firmÆs sense that quality has deteriorated.

Other Baring overweights are Mexico, Brazil, Poland and Hungary, with underweights in Japan and Europe, the latter based on hopes that these two economies pick up some of the slack from the US.

ôWe think Asian currencies are going to revalue,ö Wilde says. ôThis is going to be led by China as the US is now pursuing a less interventionist stance. Changes in the financial system were always going to be a precursor of a revaluation in the renminbi. This will also cause the yen to change and increase confidence in Europe, which has Asia as one of its major markets.ö