It was a lesson writ large by the financial crisis; dabble in carry trades denominated in dinky currencies at your own peril.
The tale of the Icelandic krona serves as a particularly brutal parable of carry traded excess.
The krona soared in the run up to the crisis as investors piled in using loans denominated in low yielding currencies.
As this now grimly prescient forex research note from the failed Icelandic bank Kaupthing in February 2007 observed:
The involvement of foreign parties in the Icelandic financial market has caused the accrual of a large amount of foreign short term capital…
It may be assumed that short term capital related to this is not under ISK 500 bn. (50% of GDP), with regard to foreign forward position of bank institutions. Short term capital of this order of magnitude is a large risk factor, when the stability of the financial system is considered.
And so a vicious circle began. A stronger krona stoked inflation in what was a small Atlantic island reliant on importing most of its goods. The Central Bank of Iceland, then under the leadership of Davíð Oddsson, a former prime minister and architect of the island’s free market reforms, was forced to raise rates.
But this only helped make the krona strengthen further. Interest rates in Japan, for example, were near zero, while by January 2006 the CBI’s policy rate had been hiked to 9 per cent. The ISK rose 49 per cent against dollar from 2002 to the end of 2007.
For many Icelanders it was a no-brainer: borrow in a low yielding currency, spend in your own, make money. Scores of Icelandic consumers used cheap foreign loans to buy cars or houses.
yen-krona carry trade circa 2007
When the bubble finally popped anyone long krona was ruined in a matter of months.
By the end of 2008 the Icelandic currency had dropped by 160 per cent against the dollar. Reports began to circulate of Icelanders blowing up their own cars to get the insurance payouts.
So, a seemingly obvious, but important question to ask, is what drove the Great Icelandic Carry?
The Icelandic example, some would argue, is extreme. A vastly overleveraged banking system, and a overheating economy were key.
But popular wisdom would take the existence of interest rate differentials as the biggest driver of carry trades the world over. As such, one would intuitively expect small currencies bearing higher interest rates to outperform those with lower interest rates.
Not entirely so, according to research by Morgan Stanley.
After mapping the relative monthly performance of a basket of non-G10 EMEA currencies based on their absolute carry (measured via base rate differentials against the US dollar), the MS analysts conclude that “the absolute level of carry is a poor predictor of future currency performance”.
Almost every currency in their basket (consisting of the Romanian leu, Hungarian forint, South African rand, Russian ruble, Turkish lira, Czech koruna and Israeli shekel) outperformed and underperformed on a monthly basis on a roughly even basis, regardless of their carry advantage.
Weak links between average carry and performance
This leads them to two conclusions:
First, relative changes in carry are tradable events. Trading strategies should be based on the direction of carry with the absolute level playing a lesser role. This conclusion supports our view that proactive central banks, such as the BoI, will ultimately generate FX strength.
Second, it seems that the actual delivery of rate changes does have an impact on the currencies, even if the move has been priced in. The 58 cases we looked at are probably enough to assume that market pricing errors around the eventual policy rate decisions were approximately normally distributed. This means that on average markets likely made no systematic errors in forecasting and that there would be no reason for currencies with changing carry to consistently out/underperform the median currency. In practice, however, as we have shown, currencies do react to changes in carry, which points to some degree of market inefficiency.
In short, someone carry trading these currencies needs to get ahead of the rate curve if they are to make money.
Not something that would have saved those squished in the Great Icelandic Carry.
Related links:
Debunking carry-trade denial – FT Alphaville
Debunking the size of the carry trade - FT Alphaville
Roubini: Mother of all carry trades faces an inevitable bust – FT
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