While the DailyFX Carry Trade Index was modestly higher over the past week, the strategy (and overall risk sentiment) is on the verge of a breakout with earnings season kicking off and signs of a deepening financial crisis popping up all over the market. Today, the carry index stood at 28,935 – 101 points above last Friday’s level. However, looking at the chart below, it is easy to grasp the pressure building behind an inevitable break in the market’s cautious stance. Since May, the basket has cut an ascending wedge with a horizontal resistance around 29,050.
[ul]
[li]Carry Nears A Breakout As Earnings Gear Up And Credit Fears Rise [/li][li]Pressure Building In Market Condition Indicators And Exchange Rates [/li][li]Freddie Mac And Fannie Mae: Evidence The ‘Financial Crisis’ Isn’t Over? [/li][/ul]
While the DailyFX Carry Trade Index was modestly higher over the past week, the strategy (and overall risk sentiment) is on the verge of a breakout with earnings season kicking off and signs of a deepening financial crisis popping up all over the market. Today, the carry index stood at 28,935 – 101 points above last Friday’s level. However, looking at the chart below, it is easy to grasp the pressure building behind an inevitable break in the market’s cautious stance. Since May, the basket has cut an ascending wedge with a horizontal resistance around 29,050. Perhaps offering a bias for the eventual trend development, market condition indicators are actually working their way lower despite improvements seen this past week. USDJPY risk reversals corrected considerably from its highest levels since last October and the volatility index is holding above the critical 10 percent figure.
The rebound in risk appetite seen from the March swing low has been slowly curbed by various signs that credit conditions and a lack of liquidity are still burdening the financial markets. Recently, a Bank of England credit report forecasted that the credit market – the life blood of investment – would worsen through the third quarter. Such a forecast is troubling considering European banks are paying the highest prices in a decade to raise capital just to meet reserve requirements, while the governmentally sponsored Fannie Mae and Freddie Mac in the US are paying record yields in their own efforts to fortify reserves. In the weeks ahead, speculation that these two lenders may require a government bailout or face bankruptcy will help to define the overall direction of risk trends; and the debate is lively. St. Louis Fed President William Poole has suggested the government step in now as the companies are essentially insolvent. Another driver for risk trends and the carry trade will be banks’ second quarter earnings numbers, which start to hit the wires next week.
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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What is the DailyFX Volatility Index (VIX):
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.
What are Risk Reversals:
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.
How are Rate Expectations calculated:
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
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.
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 Analyst for DailyFX.com
Have comments or questions on this or other articles authored by John? E-mail him at [email protected].