NEW YORK (Dow Jones)--In its 1000-year history, it hasn't been often that developments in Iceland could cause major ripples beyond its own border. But for a brief time this week, the world felt Iceland's chill.

On Tuesday and Wednesday, a meltdown in the currency and bonds of Iceland sparked a broad cooling for many emerging market and high-yielding currencies around the globe.

The catalyst for the moves was a reduction in the outlook for Iceland's triple-A rated local and double-A-minus rated foreign currency debt to 'negative' from 'stable' from Fitch Ratings.

But while the chain reaction may hold some clues as to how a major shakeout for the hot currencies and debt of emerging markets might eventually play out, for now investors don't seem to be too worried.

The scare in emerging markets followed a fairly typical pattern in which investors, alarmed by a sharp drop in one market, pull back from other markets which they deem risky.

In this case, risky seems to mean the entire gamut of emerging and high-yielding markets which have benefitted greatly over the past year amid abundant global liquidity, a grab for yield amid a dearth of attractive investments, and easy financing particularly in the form of an essentially interest-free yen.

Despite the relatively tiny size of its economy and markets, Iceland, with a benchmark rate of 10.75%, had become a poster child for that global rush for yield. In recent months, investors poured in to the extent that Icelandic bonds were "an accident waiting to happen," said Monica Fan, chief currency strategist at RBC Capital Markets in London. "It's always easier to get into these things than it is to get out."

The accident did indeed happen when Fitch revised down its outlook, citing an "unsustainable current account deficit and soaring external indebtedness."

Investors rushed for the exits from Iceland, sending its currency down 7% over Tuesday and Wednesday and pummeling its debt.

For speculative investors, that led to a broader cutback in high-yielding and emerging market positions with sharp declines in the New Zealand and Australian dollars, Brazilian real, Mexican peso, South African rand and Polish zloty among others.

In part, it was a knee-jerk move to cut back on risk, but the big factor at play, said Fan, was that investors were simply taking profits on other recently-lucrative emerging market trades to pay for their mounting losses on the krona.

"What we saw was a rush for the exit door from the Icelandic krona and bonds after Fitch's downgrade, which caused many investors to take profits on other emerging market positions to cover their losses," said Fan.

However, Fan and others note that the selloffs were not likely part of a broader wave of risk aversion. That, they say, would have been accompanied plunges in the debt and equities markets in those countries - something that was absent in this particular case.

In fact RBC Capital's proprietary measure of risk appetites, said Fan, was little changed Wednesday, registering 0.3, suggesting that the market is "still very close to neutral" on risk.


It's The Deficits

However, while analysts are fairly sanguine that there will be no broader Iceland contagion in global financial markets, many can't help but see a pattern Tuesday and Wednesday that speaks volumes about how an eventual high-yielding and emerging market shakeout will occur.

"It does seem that there is a focus on those currencies from economies where there are current account deficits," said Mitul Kotecha, head of global currency research at Calyon in London.

Kotecha downplayed the selloffs Tuesday and Wednesday as nothing more more than a flush of speculative excess in the markets. Still, he said that even if now doesn't seem the time for a major reversal of risk-seeking strategies, the selectivity seen among investors Wednesday is a telling sign of how an eventual wave of risk aversion could eventually play out.

Indeed, it's Iceland's current account deficit that got it into hot water with Fitch. But currencies in other high yielding economies with current account deficits, such as Australia, New Zealand, Turkey, Chile, and Colombia, have also seen strength in their own currencies. Even Brazil, which typically maintains a current account surplus and is expected to do so over the long term, saw its own economy go into a current account deficit of $452 million in January, raising some eyebrows and taking some of the heat out of its red hot currency.

The fact that speculators will go hunting first for currencies from economies with current account deficits is not a surprise, said Kotecha.

"There's a clear case that where the market has made the biggest speculative buildups happens to be the economies with the biggest current account deficits, and that's where people will go first to unwind" said Kotecha.


Yen For Carry

Timing of a broader pullback, however, remains a question that will have much to do with how long it remains lucrative for investors to engage in so-called carry trades, in which investors borrow in low-yield currencies to buy higher-yielding ones.

The yen fell sharply during 2005 as investors sold the Japanese currency as part of the carry trades that at the same time propped up high-yielding and emerging market currencies. That caused the yen to fall even as Japan's economic recovery built up steam and the stock market surged.

Analysts say this imbalance - short yen and long others - makes a yen bounce back an ideal trigger for a broad readjustment of currency market positioning.

There was some evidence of that Wednesday, when in the initial bout of investor jitters, the yen was bought heavily against the New Zealand and Australian dollars.

However, the real shake-out may still lie ahead. At the moment, investors are waiting to see whether the Bank of Japan will tighten its ultra-loose monetary policy stance over the next couple of months. The expectation is that the BOJ will scale back quantitative easing - the pumping of excess liquidity into the financial system - in April, marking the first stage of a policy adjustment.

Paresh Upadhyaya, portfolio manager at Putnam Investments in Boston, said that if the BOJ does move on quantitative easing in the near term, the Japanese retail and institutional investors who have been sending their savings abroad could quickly adjust their behavior and find domestic outlets to park their capital.

"Don't underestimate the effect" of a change in policy from the BOJ, said Upadhyaya. "No-one knows what will come out of this."

But in the meantime, it would pay to use caution in not overestimating the effect of things like Icelandic currency and bond selloffs.