Carry Got A Bloody Nose

Last week, a shot was heard around the world.

When the dust had settled, the Brazilian real had lost 3%. The South African rand was down 2%. The currencies of Turkey, Mexico, and Indonesia were all down at least 1%.

While these declines are not large in terms of percentage, the currency market is the world’s biggest market. These were big moves.

It started on Tuesday with a downgrade from Fitch. Fitch is a credit ratings agency, like Moody’s or Standard and Poor’s. They conduct research and issue reports on the financial health of countries and companies all around the world. But it wasn’t an actual credit rating they changed. That would have been really serious. It was only a currency “outlook.”

I bet it came from the desk of some anonymous vice-president in the London office. He probably had no idea of the trouble he was stirring. All he did was change his outlook on the currency of a tiny nation with high interest rates.

The nation was Iceland. The downgrade sparked a sell-off in Icelandic assets. Iceland’s currency – the krona – fell 10% over the next two days.

It was all a big surprise. My friend Chuck Butler – who sits on the currency desk at EverBank - said none of the large institutional currency desks on Wall Street had any idea what was going on... which explains why the news had such an impact.

For what it’s worth, Fitch’s long-term currency ratings for Iceland are still at AAA. Moody's and Standard & Poor's still have stable long-term outlooks on Iceland. If you own Icelandic investments, don’t panic. Iceland is a very small economy – only $12 billion – so dramatic fluctuations can happen.

I know more about the carry trade than most people. I used to work for the fixed income finance desk at Salomon Smith Barney... and “carry” was our bread-and-butter profit source.

“Carry” is trader talk for interest. The finance desk at Salomon would earn carry by borrowing a huge slug of bonds from one customer and then lending them to someone else at a slightly better interest rate. I used to calculate the carry on thousands of these trades, every day.

The same principal applies in the currency market. You earn carry by borrowing a currency with a low interest rate, and then converting it into a currency with a higher interest rate.

Take the Icelandic krona as an example. You borrow money in euros at 2% from a bank in Germany, convert them into krona, and deposit them at a bank in Iceland for 10%. As long as exchange rates don’t move, you make an 8% annual return. If you use leverage, you make a lot more.

This is why the events of last week were so interesting. In two days, 18 months worth of krona carry trade profit got wiped out. The Financial Timessays that traders lost so much in the krona’s crash, they had to sell off profitable positions in the Brazilian real and the South African rand to balance their books.

The big question is, where do we go from here?

Iceland still has the highest interest rates in the industrialized world. It has a top-notch credit rating and aggressive policymakers who aren’t afraid of cranking up interest rates. Interest rates in Iceland may even rise further from here, especially after Fitch’s warning and the krona’s fall last week.

Bottom line: the krona is still a very attractive currency for our bank deposits.

We must remember, however, when we buy krona, we participate in the global carry trade. We run with the hot money. Hot money is skittish and whimsical.

If you can handle the volatility, Iceland’s high interest rates make dealing with the market’s jitters well worth it. You can learn about earning 8.24% on a three-month CD by clicking here.

Good Investing,

Tom Dyson