A Sharp Reversal Threatens The Rebound In The Carry Trade And Risk Appetite

A sharp drop in high-yielding currencies and equities over the past few days may have sabotaged a crucial rebound in risk appetite and the currency market’s favored carry trade. Since last Friday, the DailyFX Carry Trade Index has dropped 336 points after briefly pushing to a new four-month high. Now, the index is threatening to officially close the rebound from March’s swing low as spot hovers just above notable support in a prevailing wedge formation.

[ul]
[li]A Sharp Reversal Threatens The Rebound In The Carry Trade And Risk Appetite [/li][li]Volatility And Risk Reversals Suggest Carry Selloff May Be Short Lived [/li][li]Are Falling Rates Among The High Yielders The Next Weight Barrier To A Realized Carry Rebound? [/li][/ul]
A sharp drop in high-yielding currencies and equities over the past few days may have sabotaged a crucial rebound in risk appetite and the currency market’s favored carry trade. Since last Friday, the DailyFX Carry Trade Index has dropped 336 points after briefly pushing to a new four-month high. Now, the index is threatening to officially close the rebound from March’s swing low as spot hovers just above notable support in a prevailing wedge formation. However, market condition indicators certainly do not support fears of an imminent breakdown in the carry and general risk sentiment. Volatility across the currency market has actually dropped 0.61 percentage points to 9.75 percent – the lowest level since late February – suggesting speculation of a potential breakout is low. What’s more, the steep drop in USDJPY risk reversals (denoting growing demand for puts) from last week has made an about face of its own…

From a fundamental standpoint, the health of risk appetite - and consequentially the carry trade - is just as mixed as the technical formation in the carry basket would suggest. On the upside, the credit and financial market fears centered on the potential collapse of Freddie Mac and Fannie Mae have eased as both lenders’ conditions seem to have stabilized. Along similar lines, market participants’ and economists’ worst case scenarios for second quarter earnings were never met. However, earnings are still down, banks have reported another round of staggering write offs and mortgage markets continue to teeter. Further adding to the pressure on risk appetite, the capital markets are still pitched into bearish territory and policy authorities are officially taking steps to depress yield differentials. Just a short-time ago, the RBNZ surprised the market with its first rate hike in years. This negative rate bias for the high-yielding currencies stands in direct contrast to forecasts for tightening for funding currencies. Going forward, the market will be closely weighing the potential for returns against the threat of volatility when gauging the future of the carry trade.

Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the [I][DailyFX Forum

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                                     [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  and   traders are expecting the pair to fall; and visa versa. 

         
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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]Carry Basket Component Currencies:

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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.

[I]Written by: John Kicklighter and Antonio Sousa, Currency Analysts for DailyFX.com

Questions or comments on this or other articles authored by John or Antonio? You can email them at <[email protected]> and <[email protected]>[/I]