A sharp sell-off in the New Zealand dollar and Icelandic krona could provoke a wider drop in foreign exchange markets, threatening the currencies of Australia, South Africa, Turkey and Hungary, analysts believe.
The New Zealand and Icelandic currencies slumped to new 22-month lows last week amid fears of recession as their economies feel the weight of high nominal interest rates and the previous strength of their currencies.
Both are also labouring under massive current account deficits – 8.9 per cent of gross domestic product in the case of New Zealand and 15.5 per cent in Iceland.
These deficits may become harder to finance as foreign investors avoid their currencies. The synchronised sell-off has led to fears that other currencies are also vulnerable if the driver of the currency market switches from the carry trade – where investors borrow in low-yielding currencies to chase higher returns elsewhere – to worries over external deficits.
“It is our contention that the foreign exchange market’s pre-occupation with interest rate differentials will be usurped by a revival in deficit concerns,” said Neil Mellor, currency strategist at Bank of New York.
“Carry is no longer king,” said Jens Nordvig, currency strategist at Goldman Sachs. “Investors were almost blindly seeking returns in emerging markets, now they will be scrutinising the fundamentals.”
From 2003 to 2005 the forex market was dominated by the carry trade. Currencies backed by high yields surged to multi-year highs, with the NZ dollar hitting its highest level against the US dollar since 1983. Japanese investors pumped $450bn (€375bn) into overseas bond markets in the four years to 2005.
Meanwhile investors, including hedge funds, borrowed in dollars and yen to fund a buying spree that has seen the MSCI Emerging Markets equity index jump 186 per cent in the past three years, and emerging market bond spreads fall from 700 basis points over Treasuries to less than 200.
However, rising interest rates in the US and eurozone, and Japan’s decision to abandon its ultra-loose monetary policy, have eroded yield differentials and threaten to curb global liquidity.
As carry trades unwind, those currencies that rose most sharply now threaten to fall just as precipitously.
The shift in currency market regime could also claim one more casualty. With the US nursing a current account deficit of 7 per cent of GDP, Mr Nordvig believes the dollar’s 15-month rally could be set to turn sour.
The New Zealand dollar last week slumped 3.6 per cent to a 22-month low of $0.612 against the US dollar last week, taking its year-to-date losses to 10.4 per cent.
The Icelandic krona also fell 5.6 per cent to a 22-month low of IKr73.18 to the greenback, cementing a fall of 16.2 per cent since January 1.
Both countries face the risk of recession as their economies groan under the weight of high nominal interest rates and hitherto strong currencies.