Interest rate expectations recharged the carry trade this past week; but a significant jump in risk aversion throughout the capital markets curbed the currency strategy. On balance, the shock from the sharp equities sell off yesterday reversed earlier gains in the DailyFX Carry Trade Index leaving the gauge 57 points lower on the week at 28,843. Supporting the air of caution in an otherwise strong carry trend, market condition indicators were reflecting modest improvements from last week. Currency traders were still relatively confident in the outlook yield demand and less concerned over the possibility of panic selling. Risk reversals for USDJPY (the proxy for the carry) rose as calls grew in value; and the DailyFX Volatility Index fell back below 10 percent following last week’s unexpected jump.
• A Sharp Drop In Risk Appetite Cuts A Possible Carry Trade Breakout Short
• Credit Market Conditions Improve While Capital Markets Tumble, Is This A Natural Bear Market?
• Interest Rate Differentials May Not Offset Possible Capital Losses With Risk Rising
Interest rate expectations recharged the carry trade this past week; but a significant jump in risk aversion throughout the capital markets curbed the currency strategy. On balance, the shock from the sharp equities sell off yesterday reversed earlier gains in the DailyFX Carry Trade Index leaving the gauge 57 points lower on the week at 28,843. Supporting the air of caution in an otherwise strong carry trend, market condition indicators were reflecting modest improvements from last week. Currency traders were still relatively confident in the outlook yield demand and less concerned over the possibility of panic selling. Risk reversals for USDJPY (the proxy for the carry) rose as calls grew in value; and the DailyFX Volatility Index fell back below 10 percent following last week’s unexpected jump.
The carry trade is in an interesting position this week. On the one hand, many of the benchmark carry pairs are still near the highs of their respective rallies – and the recent pull back has certainly not threatened the hearty trends. Conversely, the capital markets have undergone a clear reversal in risk sentiment with equity markets tumbling to new lows. In fact, with Thursday’s close, the Dow was at its lowest level since November of last year while European shares plunged to levels not seen since November of 2005. With USDJPY over 1,100 points above its own multi-year low and the Dow just now pressing to fresh lows, it seems that the risk correlation is breaking down. However, this has likely been facilitated by steady improvements in the credit market which leads us to believe the bearish turn in capital market’s is of a ‘natural’ sort and not the panic surrounding investment stability from last summer. Nonetheless, a decline in equity markets generally suggests risk appetite and yield are on the wane – unfavorable conditions for carry. Furthermore, with the Fed and ECB threatening hikes and RBNZ seeing cuts while the RBA holds, the potential for return is fading as risk rises.
[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.
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[B]Risk Indicators:[/B]
[B]Definitions[/B]:
[B]What is the DailyFX Volatility Index (VIX):
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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.
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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]How are Rate Expectations calculated:[/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]Carry Basket Component Currencies:
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[B] Additional Information[/B]
[B]What is a Carry Trade[/B]
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.