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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.

Posted by Felix at 0:49 EST

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