The global carry trade

It’s good to see that global financial markets can still get volatile occasionally.

Last week the Icelandic krona fell 9% in two days for no real reason: the plunge

was precipitated by a ratings downgrade from Fitch. Of course, people sold the

krona not because they feared an Icelandic default but because, well, everybody

else was selling the krona. And if everybody’s selling, then the carry-trade

salad days are coming to an end.

Brad Setser has some very

good analysis on all this. Of course, being Brad Setser, he feels compelled

to mention that Iceland was running a large current-acccount deficit. But Iceland’s

current-account deficit, as Brad knows full well, was no more the cause of the

krona’s fall than the Fitch downgrade was. The point is that currencies which

benefit from the carry trade are always going to be in a precarious position,

because there’s no hotter money than the money which is sitting in overnight

bank accounts run by traders with hair-trigger reflexes.

Here’s how it works: hedge funds, and prop desks, borrow money at something

less than 5%, and then buy the Icelandic krona, which yields something more

than 10% thanks to the central bank desperately trying to cool down an overheating

economy. It’s a great trade, unless and until there’s a sudden fall in the krona,

which can – and did – wipe out a year’s worth of carry in a day

and a half.

Where does this leave Brazil? I still think the Brazilian carry trade is a

no-brainer. It doesn’t even really matter where you’re borrowing: it can be

in yen at 0%, or in Swiss francs at 1%, or in euros at 2.25%, or in dollars

at 4.5%. The only number worth concentrating on is where you’re investing: in

Brazilian reais at 17%. No credit rating agency is going to downgrade Brazil

any time soon, I can assure you. And Brazil doesn’t have a current-account deficit,

so there’s no "natural" downward pressure on the currency. Yes, there’s

an election this year, which can cause volatility, but the worst-case scenario,

as far as the markets are concerned, is the status quo of a continuation Lula

government.

The krona collapse spilled over into Brazil (now there’s a textbook

example of contagion for you) not because traders were worried about Brazil

being next, but because they’d made so much money in Brazil that they needed

to cash out some of their positions there in order to cover losses in Iceland.

Smart investors will have treated the Icelandic affair as a fantastic Brazilian

buying opportunity.

My feeling is that the good times will come to an end in Brazil, as good times

always will. But it won’t be because of a collapse in the value of the Brazilian

real, so much as it will be due to a slow decrease in Brazilian interest rates,

combined with a slow increase in interest rates in the rest of the world. For

the time being, however, if I had any money to invest, I’d put it in Brazilian

reais.

Extra Credit Question: What happens to the dollar if and when the global carry

trade is unwound? I don’t think anybody knows the answer to that one. Historically,

the dollar has been the recipient of the flight-to-quality trade, which is the

opposite of the carry trade. On the other hand, as Brad notes, "can the

currency of a country with a $1 trillion external deficit really offer a safe

haven in an uncertain world?" And if it can’t, what will the new safe haven

be? Will people put even more money into property? It seems unlikely,

although no more unlikely than anything else.