The pullback in risky assets and the carry trade since the beginning of June was curbed over the past few days as interest rate expectations settled and risk appetite found a foot hold. Along with a pick up in equities, junk bond yields and credit products, the carry trade received a boost. The DailyFX Carry Trade Index rose 352 points from last Friday to 28,882 – the highest level for the gauge since the beginning of the month. Suggesting the rebound in carry is genuine, USDJPY risk reversals improved modestly bringing the forward-looking indicator closer to a major reversal. At the same time, the DailyFX Volatility Index has dropped nearly 0.7 percentage points over the week as currency options traders foresee more stable market conditions ahead.
• Carry Trade Rises As Rate Expectations Reinforce Yield Differentials
• Is The Credit Market Heading For A Full Blown Crash?
• Market Conditions Improving, But Volatility And Spread Outlook Still Unfavorable
The pullback in risky assets and the carry trade since the beginning of June was curbed over the past few days as interest rate expectations settled and risk appetite found a foot hold. Along with a pick up in equities, junk bond yields and credit products, the carry trade received a boost. The DailyFX Carry Trade Index rose 352 points from last Friday to 28,882 – the highest level for the gauge since the beginning of the month. Suggesting the rebound in carry is genuine, USDJPY risk reversals improved modestly bringing the forward-looking indicator closer to a major reversal. At the same time, the DailyFX Volatility Index has dropped nearly 0.7 percentage points over the week as currency options traders foresee more stable market conditions ahead.
Though the carry trade has improved week-over-week, the conditions underlying the rebound are a little shaky. One of the primary drivers for the rebound in yield demand was a broad improvement in other risky assets. However, in just the past few days, a number of analysts have offered bleak forecasts for the US economy and the financial markets. Recalling the panic of the sub-prime meltdown of last summer, an RBS report this week suggested the credit and equity markets were heading for an authentic crash within the next three months. Less alarmist, but just as concerning, the hedge fund manager John Paulson (who notably called the initial subprime collapse and credit crunch) suggested total write downs will eventually total $1.3 trillion, while Goldman Sachs suggested banks will need to raise at least another $65 billion in capital to offset ongoing credit losses. Another doubtful contribution to this week’s carry improvement was the slackening in forecasts for a Fed rate hike. However, with the BoE, RBA and RBNZ signaling they are not looking to raising rates anytime soon, yield differentials may actually close in the months ahead if the Fed follows warnings with action.
[I]Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum[/I]
[B]Risk Indicators:[/B]
[B]Definitions[/B]:
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[B]What are Risk Reversals:[/B]
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 (as implied volatility for puts is quoted as a negative percentage and implied volatility for calls is quoted as a positive percentage) 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.
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[B][/B]Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe the market prices influences policy decisions). To take advantage of the collective wisdom of the market in forecasting rate decisions, we will use a combination of long and short-term, risk-free interest rate assets to determine the cumulative movement the Bank of Japan will make over the coming 12 months. We have chosen the Bank of Japan as the yen is considered the proxy funding currency for carry trades.
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.
[B]Additional Information[/B]
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.
[B]Carry Trade As A Strategy[/B]
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.