What does Iceland’s decision to raise its key interest rate to 15% yesterday have to do with the strength of the greenback? Plenty, according to currency experts. As other countries strengthen their currencies, the Federal Reserve has been loosening its monetary policy, creating a yawning gap between the yields on the dollar versus other currencies. Investors are taking advantage of this differential, selling dollars and buying higher-yielding currencies, a strategy known as a “carry trade.”

In a carry trade, a trader borrows dollars from a bank, converts the funds into Icelandic krona, for example, and buys an Icelandic bond for the equivalent amount. If the bond is paying 15%, and the American interest rate is just 2.25%, the trader can make a profit off this differential, a whopping 12.75 percentage points.

Traditionally, the Japanese yen has been the currency of choice for a carry trade because the interest rate is close to zero. But as the Japanese currency has been strengthening, and the Federal Reserve continues to slash rates, investors are now looking at the dollar as a replacement currency. “It is pretty pathetic that the world’s reserve currency is now being used as the carry trade currency,” an investment strategist at Miller Tabac + Co., Peter Boockvar, said.

The Fed cut its key interest rates by three-quarters of a percentage point last week to 2.25%, its sixth rate cut since September. It is expected to cut rates by another quarter of a percentage point when the Federal Open Market Committee meets on April 30. These rate cuts have pushed down the value of the dollar against other currencies, including those that it normally trumps, such as the Swiss franc, Canadian dollar, and the Japanese yen.

Yesterday, the dollar continued its freefall, dropping to $1.56 against the euro, its lowest level in two weeks, on news that consumer confidence has dropped to a five-year low, a fall in home prices, and a report from Deutsche Bank predicting the economy will suffer a recession.

While the dollar as the currency for a carry trade makes sense, experts caution the strategy comes with risk, namely volatility. To accomplish a carry trade, traders borrow large amounts of the lower-yielding currency, like the dollar, to buy bonds denominated in a higher-yielding currency. If the dollar were to suddenly strengthen, for example, traders who must pay back the banks from which they borrowed the dollars may find it more costly than the yield differential they were generating from the carry trade.

“For the carry bet to really work, the market cannot be so volatile,” a partner at Foreign Exchange Analytics, David Gilmore, said. “If we go back to a world of relative calm and benign risk, then yes, I can see the dollar becoming a funding currency for the carry trade, but at this point I don’t think there is much chance of that happening.” Another challenge for a dollar-denominated carry trade is the fact that banks are extremely risk averse in the current environment and may not be willing to lend to traders hoping to execute this kind of strategy. “We are in the midst of a crisis in the financial markets where we have whole markets drying up,” a senior economist at Moodys.com, Tu Packard, said. “Banks are very risk averse right now and are looking more carefully to whom they are lending, making it very hard for traders to borrow the money to execute a carry trade.”

Still, foreign exchange traders say there are some taking the plunge. “The dollar is now lower than the Swiss frank and many other currencies, therefore there is a big fundamental shift causing investors to borrow dollars and invest in higher-yielding assets abroad,” a trader and author of a book on foreign exchange trading, Abe Cofnas, said.

And in the last few days the credit markets have begun stabilizing, with some traders looking to jump into the action.

“People want to believe there’s a bit more calm in the markets,” the head of foreign exchange sales in Tokyo at Lehman Brothers Holdings, Toru Tokoyoda, told Bloomberg yesterday. “That brings yield differentials into focus, which tends to favor the euro against the dollar. This is a type of dollar carry trade.”