Is the Carry Trade Kaput?

New Zealand interest rates have remained stubbornly high at 8.25% for months, which while not great for domestic borrowers, have been a boon to carry trade investors. This elite group borrows in a low-yield currency to buy debt instruments in a high-yielding economy and pocket the difference as profit. But the cheap source of funds has provided a steady supply of capital to invest in a variety of markets around the globe.

Interest rates in Japan have remained near 0.5% providing carry trade investors with an almost endless supply of cheap funds. As long as the spreads between source and target nations remained high and currencies didn’t fluctuate wildly, the investor pocketed the difference between the two as profit. However, if the target currency [NZD] weakens substantially against the base [JPY] it can spell trouble. As we see from Figure 2, the NZD has weakened versus the JPY substantially since mid 2007. This currency pair is an excellent proxy for the health of the global carry trade.

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Figure 2 – Weekly chart of the New Zealand dollar/Japanese yen currency pair that is an excellent proxy for the carry trade. Chart by GenesisFT.com

Another popular target of carry trade investors has been the Iceland, but the krona was the biggest loser against the dollar among the 177 currencies monitored by Bloomberg Friday on concern financial firms will suffer from the global credit freeze. The risk of Iceland's biggest banks defaulting rose above 49% based on credit-default swap [CDS] premiums. Since November 6, the krona has fallen more than 40% against the euro, dropping to a record low against that currency putting carry trade investors seriously underwater. It is down 32% against the beleaguered dollar since November. The Icelandic central bank unexpectedly raised interest rates to 15 percent this week and sold 7.15 billion krona ($93 million) of debt Friday in attempts to shore up the currency.

Credit-default swaps on the Icelandic banks are more than 10 times higher than the average for European lenders as the credit market freeze prompted investors to shun all but the safest assets. Premiums on the krona indicate very distressed levels according to Matthew Hegarty, a credit analyst at Barclays Capital in London interviewed by Bloomberg. “Credit spreads are implying there's a chance of default over the next five years. Not a probability, but a real possibility,” according to the March 28th article.

Why is this important? Since the carry trade has generated a ready supply of funds for global investors including hedge funds and institutions, it has been an important driver behind an array of asset classes including equities and commodities markets in the last few years. As the damage swath cut by the credit crunch widens, it is having many unanticipated repercussions. A squeeze of the carry trade is one clear example. But just how much it will impact other markets remains to be seen.

However, one thing is clear. Recent events across the Atlantic and South Pacific show that the much-hoped-for end to the credit crisis is anything but near at hand.