The Bear Stearns of the North Atlantic

Now, we look at the Bear Stearns of the North Atlantic - Iceland.

From Ambrose Evans-Pritchard in the Telegraph:

"Fitch said countries that run current account deficits above 10pc of GDP for any length time almost always come to grief. East Asia's debt crisis in 1997 erupted before any state reached double digits. Iceland's deficit is now 16pc of GDP. Latvia is at 25pc, Bulgaria 19pc, Georgia 18pc, Estonia 16pc, Lithuania 14pc, Romania 14pc and Serbia 13pc. The region will need $337bn in foreign loans this year.

"Borrowing in foreign currencies was all the rage in the heady days of the credit bubble. Most mortgages in Hungary over the last two years have been in Swiss francs, with the Balkans and Poland not far behind. This is now turning into slow torture. The franc has risen 5pc against the euro since October. The real level of the debt is ratcheting up.

"The foreign debts have reached 122pc of GDP in Latvia, 101pc in Estonia and 73pc in Lithuania, mostly in euros. For now the debtors are shielded by fixed exchange rates in Europe's ERM system, but this could make the shock even worse should the currency pegs start to snap."

And this from our old friend, Steve Sjuggerud. "Is it time to buy Icelandic bonds?" we wondered.

"Well, the bonds sure should be a good buy...

"I haven't watched this too closely... But I think this is the basic story over the last week...

"Carry traders got margin calls from their banks. That forced a large amount of money out of a small currency (Iceland's krona), which caused it to depreciate.

"Short sellers caught on, knowing that the carry traders had to close out their positions, causing the currency to fall faster... then SURPRISE...

"The central bank caught everyone off guard and raised short rates to 15%(!) and took other drastic measures.

"So now...you've got short rates at 15%. You've got a currency that is significantly oversold (cheap) now relative to its history (it's always expensive), in a country with a triple-A credit rating and no risk to government finances. (The only risk is they're the perceived lender of last resort to Iceland's leveraged local banks)

"The currency is always volatile. But buying short-dated paper, with a 15% 'tailwind' in a triple-A rated country, when the currency has backed off so much, ought to be a good trade.

"As you probably know, I prefer the inflation-indexed long-dated bonds to t-bills, because the capital gains potential could be huge...

"Icelandic TIPS pay 4.5% now, plus inflation (which should be 6% this year). So that's a double-digit yield. But the TIPS go out as far as 2044... so the capital gains on those long dated bonds would be huge if the real yield fell from 4.5% to 3.5% or lower.

"A real yield of 4.5% is ridiculous. My thesis all along is the capital gains portion of the trade... but one thing after another has kept that real yield high.

"The currency is the big risk. Its volatility can't be taken lightly. But when you think about it, it's foolish to short a AAA currency yielding 15%. So now should be a good time to put the trade on..."

Bill Bonner
The Daily Reckoning Australia

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