The health of the carry trade is dependant on a foundation of high returns (wide yield differentials) and low volatility (or perceived risk). Considering the outlook for global interest rates has plunged over the past weeks and broad fears are growing out of a global slowdown in growth and lingering threats to the financial system, it makes sense that the carry trade has tumbled recently.
• The Carry Trade Plummets To Two Year Lows As Risk Appetite And Yields Shrivel
• Momentum Building In Carry Unwinding With DailyFX Carry Index Down 1,284 Points
• Market Condition Indicators Slow To Pick Up On The Panic Selling
The health of the carry trade is dependant on a foundation of high returns (wide yield differentials) and low volatility (or perceived risk). Considering the outlook for global interest rates has plunged over the past weeks and broad fears are growing out of a global slowdown in growth and lingering threats to the financial system, it makes sense that the carry trade has tumbled recently. With the high yielders on the retreat and capital finding its way back into funding currencies like the Japanese yen and Swiss franc, the DailyFX Carry Trade Index has collapsed this past week by losing another 1,284 points. This incredible move has brought the total decline from the mid-July swing high to 2,933 points and led the index to its lowest level since May 2006. On the other hand, while it is clear that aggressive and panic selling is dominating the market, market condition indicators haven’t really caught up to drop in price. Risk reversals slipped 0.74 percentage points, but are only at two-month lows. At the same time the broad currency volatility has barely tested its range high.
Technically, there doesn’t seem to be a valid floor to stem the losses for the carry unwinding in either the individual risk-sensitive currency pairs or in the aggregate index. This seems to suit the fundamental facet of this decline well. Scanning the economic data and news over the past few weeks, there doesn’t seem to have been any specific triggers that would set off such an overwhelming flight from risk. However, the pressure has certainly been building up with time. Concern over risk (volatility) has been consistently stoked by speculation that the failure of a major financial institution would send global markets into turmoil. So far, the highest probability targets are a Freddie Mac/Fannie Mae combo or Lehman Brothers. With the failure rate among US banks at its highest level in 14 years, a bank collapse will remain an imminent treat. For the GSE’s a sizable sum of debt is due to mature in later this month, which should test their capitalization and the market’s tolerance. The newer (and perhaps more catalyzing) concern is the sharp reduction in expected returns. Both the RBA and RNBZ have cut their rates and signaled further easing down the line. With the market expecting the ECB, BoE and Fed expecting to follow suit later on, the yield differentials on the most liquid carry trade pairs simply can’t compensate for risk.
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Risk Indicators:
Definitions:
What is the DailyFX Volatility Index:
The DailyFX Volatility Index measures the general level of volatility in the currency market. The index is a composite of the implied volatility in options underlying a basket of currencies. Our basket is equally weighed and composed of some of the most liquid currency pairs in the Foreign exchange market.
In reading this graph, whenever the DailyFX Volatility Index rises, it suggests traders expect the currency market to be more active in the coming days and weeks. Since carry trades underperform when volatility is high (due to the threat of capital losses that may overwhelm carry income), a rise in volatility is unfavorable for the strategy.
USDJPY 25 Delta Risk Reversals 3 Month
Risk reversals are the difference in volatility between similar (in expiration and relative strike levels) FX calls and put options. The measurement is calculated by finding the difference between the implied volatility of a call with a 25 Delta and a put with a 25 Delta. When Risk Reversals are skewed to the downside, it suggests volatility and therefore demand is greater for puts than for calls and traders are expecting the pair to fall; and visa versa.
We use risk reversals on USDJPY as it is the benchmark yen pair and the Japanese currency is considered the proxy funding currency for carry trader. When Risk Reversals grow more extreme to the downside, there is greater expectations for the yen to gain – an unfavorable condition for carry trades.
Bank of Japan Rate Expectations
To read this chart, any positive number represents an expected firming in the Japanese benchmark lending rate over the coming year with each point representing one basis point change. When rate expectations rise, the carry differential is expected to contract and carry trades will suffer.
Additional Information
What is a Carry Trade
All that is needed to understand the carry trade concept is a basic knowledge of foreign exchange and interest rates differentials. Each currency has a different interest rate attached to it determined partly by policy authorities and partly by market demand. When taking a foreign exchange position a trader holds long position one currency and short position in another. Each day, the trader will collect the interest on the long side of their trade and pay the interest on the short side. If the interest rate on the purchased currency is higher than that of the sold currency, the result is a net inflow of interest. If the sold currency’s interest rate is greater than the purchased currency’s rate, the trader must pay the net interest.
Carry Trade As A Strategy
For many years, money managers and banks have utilized the inflow and outflow of yield to collect consistent income in times of low volatility and high risk appetite. Holding only one or two currency pairs would invite considerable idiosyncratic risk (or risk related to those few pairs held); so traders create portfolios of various carry trade pairs to diversify risk from any single pair and isolate exposure to demand for yield. However, even with risk diversified away from any one pair, a carry basket is still exposed to those conditions that render this yield seeking strategy undesirable, such as: high volatility, small interest rate differentials or a general aversion to risk. Therefore, the carry trade will consistently collect an interest income, but there are still situation when the carry trade can face large drawdowns in certain market conditions. As such, a trader needs to decide when it is time to underweight or overweight their carry trade exposure.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions? Comments? Send them to jkicklighter@dailyfx.com. 
The Carry Trade Plummets To Two Year Lows As Risk Appetite And Yields Shrivel
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