This year the Icelandic markets, and especially the kronur, have been much like the canary previously used for detecting toxic gases in coal mines. When the canary "fainted", it was time to get out of the mine. Similarly, when the Icelandic canary has "fainted" this year, it has indicated that it was time to reduce exposure to Iceland and Emerging Markets, as well as to high yielders like the New Zealand dollar.

 We have taken a look at the simple correlation between the ISK and a number of EM and high-yielding currencies - the ZAR, TRY, PLN, HUF, IDR, PHP, BRL and NZD (see graph below). The results are striking, and some clear conclusions can be drawn from the numbers.

 First, the correlation between all the EM/high-yielding currencies has been extremely high this year (75- 90%). Second, the ISK has tended to lead the other currencies in the "sample". This is especially true of the highest yielding currencies like the TRY, BRL, IDR and PHP, while the PLN, HUF and NZD seem to be moving more in sync with the Icelandic currency. This year, the ISK has typically led the TRY, BRL, IDR and PHP by 20-30 trading days. The lead versus the ZAR has been somewhat longer (around 60 trading days).

 Of course, this is a very simple “study”, and one should be careful not to read too much into the results. For example, it is well known that correlations like this tend to change over time. If we look at 2005, for instance, the correlation between the Emerging Markets currencies and the ISK is much less clear. That said, we think there are good reasons for tracking developments in the ISK (and maybe also the NZD) as leading indicators of the way EM currencies will be heading.

 The ISK (and NZD) have weakened somewhat (at least against EUR) since late October - and yesterday the kronur dropped nearly 2%. The recent trends in the ISK could be an indication that its rally since the end of June has come to an end, and more weakness could be on the cards as investors take profit towards yearend. Judging from the correlation in 2006, this could indicate that one should begin to be more careful about long positions in EM currencies. If the weakness in the ISK continues in the coming days and weeks, we would clearly see this that as a (partial) indicator of renewed weakness in EM currencies - and we would especially recommend caution in the case of the TRY and HUF. Like Iceland, both Turkey and Hungary are running large current account deficits. That said, the ISK is only a partial indicator, and so it cannot be used alone. We would also look carefully at global bond yields - if G3 yields start heading upwards again, clearly that would also be a sell signal in Emerging Markets.