Brad Setser: Carry traders and today's currency markets

Brad Setser has an excellent and to the point post about carry traders (see also here and here) and their influence on the financial/currency markets. He starts of in Iceland with the recent drop in the Krona but as also implied by the title of his post, carry trade is really a phenomenon on whose back a butterfly can potentially start a hurricane.

"It is good to get into carry trades early - you get the high interest rate and watch as other investors bid up the currency too.  But it is not so good to get in late - falls in the currency can offset the gains from higher interest rates.

And I guess some folks started to get a bit nervous.   Fitch downgraded Iceland, the krona fell sharply, and downward movement in the krona led to downward moves in Brazil, South Africa, Indonesia, Poland, Mexico and Turkey.

Why, you might ask, does what happens in Iceland matter to Brazil?   Or Turkey? 

Their economies are not exactly any more similar than their cultures. The answer is that all are linked together by common set of carry-driven investors."

(...)

"Well, big bets gone awry are a potential source of systemic risk.   Ragu Rajan of the IMF has warned that investors are forced to take on ever-increasing amounts of tail risk (the risk of really bad outcomes) to eke out the high returns needed to justify their management fees.    Tim Geithner has warned, consistently, against betting too heavily that a world with massive imbalances will be a very financially stable world.   Those betting on continued stability are betting either that imbalances won't unwind, or that they will unwind in ways that don't lead to major turbulence in financial markets."

Go see the posts, the links/references and join the discussion through the comments; I really believe it is a telling and informative post.