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Generational Dynamics Web Log for 27-Feb-06
Sudden collapse of Iceland krona portends bursting of "carry trade" bubble

Web Log - February, 2006

Sudden collapse of Iceland krona portends bursting of "carry trade" bubble

I don't normally write about international interest rates because there's a lot to explain, and frankly it's a lot easier to talk about the stock market bubble and the housing bubble, and a lot easier for readers to understand. Relatively speaking, it's easier to understand how the Fed's near-zero interest policy has created the housing bubble and has perpetuated to the stock market bubble, to the point where today it's overpriced by a factor of over 220%, making it highly vulnerable to a panic.

And besides, all these bubbles are heavily linked together, so that when one of them bursts and crashes, the other ones will too.

But the events of the past week in Iceland and Japan, and their domino effects on other nations, make it time to discuss the bubble in international interest rate trading, known as the "carry trade," and why the expected bursting of this bubble in the next few months is going to be particularly gruesome.

How the carry trade works

You're probably aware that the Federal Reserve Bank sets the "Fed funds rate" or the "overnight interest rate" for the dollar. This is the interest rate at which banks loan money to each other

Every country has its own central bank (with a single central bank for the European Union) that decides the bank lending rate for that nation's currency. Here's a list of the current interest rates for different countries:

    Country         Interest rate
    --------------  -------------
    Japan            0 %
    Switzerland      1 %
    Sweden           2 %
    Eurozone         2.25 %
    United States    4.5 %
    New Zealand      7.25 %
    Iceland         10.75 %

If you look at this table for a moment, you might get an idea of what a "carry trade" is. The interest rates are different. That means that you can do the following (if you're a bank or major investor):

Borrow a ton of money -- Japanese Yen -- from Japan at 0% interest. That means you'll have to pay the money back, but you won't have to pay any interest.

Convert the money into US dollars.

Lend the money to a bank at 4.5% interest. If it's a million dollars, then you'll earn $45,000 per year in interest.

At some point, convert the money back into Japanese Yen, return the money you borrowed, and pay no interest.

So that's what a carry trade is -- it uses the differential between two different countries' interest rates to make money. All you have to do is borrow money at a low or zero interest, then lend it to someone at a high interest rate, and you make money. In the above example, you've made $45,000 without risking any of your own money. It's easy, right?

Big complication: Exchange rates

Well, there's a big complication, having to do with exchange rates. In the above example, you have to convert yen to dollars, and later convert dollars to yen. Those conversion rates can change, and that makes things even trickier.

In this case, the exchange rate has favored the speculator. A year or two ago, the exchange rate was 105 yen per dollar. Today, the exchange rate is 116 yen per dollar. This has been great for the speculator. He borrowed a ton of Japanese yen, converted them to dollars at 105 yen per dollar, and then lent the dollars to someone at 3.5-4.5% interest. During that period, the dollar became more valuable, and the yen became less valuable, so he needed about 10% fewer dollars to get the same amount of yen as he previously had. So he made money on interest, and also made money on currency exchange.

Iceland króna bloodbath

Take a look at the table above, and you'll see that Iceland has the highest interest rate shown -- 10.75%. This makes Iceland a very attractive place to lend money. A speculator can borrow money in euros from a European bank at 2.25%, convert it to Iceland krónas, and lend it at 10.75%, making 8.75% per year.

Many speculators have done exactly that, though here's an interesting side note: Nobody knows how much money is out there in carry trades, in Iceland banks or anywhere else.

Anyway, on Wednesday, the Fitch Ratings agency (along with S&P and Moody's, one of the three major international investment ratings agencies) issued a new rating on Iceland's banks, revising the country outlook for Iceland from "stable" to "negative," citing macroeconomic imbalances. (Paragraph corrected - 1-Feb-2009)

According the analysis released by Fitch:

"[The ratings] take into account Iceland's macro-prudential risks, including rising inflation, rapid credit growth, buoyant asset prices, a steep current account deficit and escalating external indebtedness. For [KB-bank, Landsbanki and Islandsbanki] these risks are offset to some extent by the banks' large capital bases, with Tier 1 ratios of 9.4%, 11.9% and 9.9% respectively at end-2005, and by the significant geographic diversification of their loan portfolios, with foreign lending representing between around 35% and 70% of the banks' loan books at end-2005."

(By the way, does the stuff about "rapid credit growth, buoyant asset prices, a steep current account deficit and escalating external indebtedness" remind you of some other country you may have heard of -- like the United States?)

The publication of Fitch's rating caused an immediate collapse in the value -- the exchange rate -- of the Iceland króna, which fell 9.3% against the dollar in just two days. This means that speculators making an 8.25% interest rate differential suddenly lost all their profit in a currency exchange rate revaluation.

A chain reaction

The Iceland collapse created a chain reaction that threatened numerous emerging markets from Brazil to Indonesia.

The reason is that many hedge funds and currency speculators suddenly lost a lot of money, forcing them to issue sell orders in other places in order to meet their payment commitments.

The Brazilian real fell 3%, the South African rand more than 2%, the Indonesian rupiah and Polish zloty 1.5%, and the Mexican peso and Turkish lira 1%.

"These countries may be unrelated geographically but they are not unrelated in portfolios," said Tony Norfield, global head of Foreign Exchange (FX) strategy at ABN Amro. "What starts as a trimming back of a position can turn into an avalanche."

However, the panic was short-lived, and seems to have been resolved by the end of the week. Iceland, Brazil, Mexico and other countries immediately announced that they would defend their currencies either by raising interest rates further or by buying back their currency with dollars.

Yen revaluation

Like the stock market and housing, there's a "carry trade bubble," and it's going to have to unwind in the next few months.

The major source of the carry trade bubble has been Japan's 0% interest rate. This one interest rate has created huge positions in currencies around the world, possibly as much as billions of billions of dollars. All of these positions are based on the assumption of 0% interest rates to be paid back to the Bank of Japan.

What happens if the Bank of Japan suddenly decides to raise its interest rates -- just as the Fed has been doing? Well, that's exactly what the Bank of Japan has indicated that it plans to start doing.

This will have infinitely more impact than the little dust-up last week of the collapse of the króna. Few investors were deeply into the króna, but astronomically many more are depending on the yen interest rate.

"There are several hundred billion dollars of positions in the carry trade that will be unwound as soon as they become unprofitable," said Stephen Lewis, an economist at Monument Securities, quoted by The Telegraph. "When the Bank of Japan starts tightening we may see some spectacular effects. The world has never been through this before, so there is a high risk of mistakes."

Stephen Roach, chief economist at Morgan Stanley, warns that the carry trade is itself, in all its forms, a major cause of dangerous speculative excess. "The lure of the carry trade is so compelling, it creates artificial demand for 'carryable' assets that has the potential to turn normal asset price appreciation into bubble-like proportions," he said.

"History tells us that carry trades end when central bank tightening cycles begin," he said, quoted by The Telegraph.

Generational financial crisis cycles

From the point of view of Generational Dynamics, what we're headed for is a new 1930s style Great Depression, as we've said many times before.

But this "carry trade" issue adds a new dimension to it.

Generational financial crises affect the entire world economy. They occur roughly every 80 years, the length of maximum human lifespan, when the generation of people who remember the previous crisis all disappear (retire or die), all at once. The past few are Tulipomania bubble (1637), South Sea Bubble (1721), French Monarchy bankruptcy (1789), Hamburg Crisis of 1857, and 1929 Wall Street crash.

What all of these financial crises have in common is that they were based on an exponentially increasing credit bubble that eventually bursts. A person who survives the horror, homelessness and starvation of a major financial crisis invariably becomes a very risk-averse adult, and makes only the most cautious financial investments. As the generation of people who lived through the last financial crisis disappear, they leave behind younger generations of people with no personal memory of the previous financial crisis. They are much more risk-seeking, and they make more and more risky investments, creating a new credit bubble, leading to a new financial crisis.

For example, the Tulipomania bubble occurred in the early 1600s. Tulips were the "high tech" items of the day. By means of breeding experiments, Dutch botanists were able to produce tulips with spectacular colors. These tulips were sought by wealthy people, and by 1624, one particularly spectacular bulb sold for the cost of a small house. Prices kept going up until the market for tulip futures crashed in 1637.

International financial crises are often based on whatever "high tech" means for the day. The 1857 bubble was based on railroad expansion, the 1929 crash was based on the automobile, and the 1990s bubble was based on internet technology.

Each successive international financial crisis affected more and more of the world. The Tulipomania bubble affect mostly Western Europe. By 1857, all of Europe and North America were affected. The 1929 crash affected Japan and some other Asian countries.

Today, the carry trade bubble means that every country in the world is going to be affected. This will be the biggest and most far-reaching financial crash the world has ever seen. (27-Feb-06) Permanent Link
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Generational Dynamics Web Log for 27-Feb-06 Sudden collapse of Iceland krona portends bursting of "carry trade" bubble