Last week’s pull back in the carry trade has turned into a full-blown reversal as yield differentials contract and risk aversion rise. This past week, the DailyFX Carry index fell 364 points to 28,489 – brining it back below the falling trendline that had been breached in an upside break at the end of May. This reversal comes with significant support from market condition indicators. Volatility – an unwanted factor when looking to collect steady income on the carry – marked a significant rebound as other risky assets accelerated recent losses. The DailyFX Volatility Index in fact jumped 0.37 points to 10.7 percent. At the same time, yield differentials have narrowed with interest rate products pricing in 43 bps of tightening from the BoJ over the coming year.
· Carry Trade Advance Fails As Yield Forecasts Favor Carry Currencies
· USDJPY The Stand Alone Clear Bull Among The Yen Crosses
· Volatility On The Rise As Risk Appetite Falls Across The Financial Market
Last week’s pull back in the carry trade has turned into a full-blown reversal as yield differentials contract and risk aversion rise. This past week, the DailyFX Carry index fell 364 points to 28,489 – brining it back below the falling trendline that had been breached in an upside break at the end of May. This reversal comes with significant support from market condition indicators. Volatility – an unwanted factor when looking to collect steady income on the carry – marked a significant rebound as other risky assets accelerated recent losses. The DailyFX Volatility Index in fact jumped 0.37 points to 10.7 percent. At the same time, yield differentials have narrowed with interest rate products pricing in 43 bps of tightening from the BoJ over the coming year.
A rising wave of risk aversion has swept over most financial market this past week; and the carry trade was just another one of the victims. Selling pressure has overwhelmed the rebound in equities, government debt yields and yen and franc currency crosses as central banks the world over turn to hawkish rhetoric - that distinctly threatens rising interest rates sooner rather than later - even though economic expansion is still struggling. The interest rate component of this flight from risk would usually benefit the yield-dependant carry trade; but the policy outlook has actually worked against wider differentials. The interest-heavy New Zealand dollar has received confirmation from the RBNZ that a cut is on the way. Less action oriented, the Aussie central bank is just now coming into a concerning slowdown in economic activity. On the low end of the curve however, the market is pricing in a near 47 percent chance of a Fed hike in August and 139bps of cumulative tightening over the year. Even the BoJ is now looking at 41bps of firming by next year.
[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]
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[B]Risk Indicators:[/B]
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What is the DailyFX Volatility Index (VIX): [/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.