The global credit crunch seems to be loosing its grip on the financial markets; and in its place, improving liquidity levels and growth outlook have revived a taste for risk. For the currency market, the appetite for yield boosted the DailyFX Carry Trade Index $123 to $29,020 and extended a modest yet steady advance for the basket. What’s more, with this past week’s strength, the market seems to have pushed through resistance in a descending trend channel that has guided carry lower since the subprime meltdown last summer. Alongside the improvement in price action, market activity indicators similarly improved. The DailyFX Volatility Index edged closer to the 10 percent-mark as fears of major capital losses ease. At the same time the directional risk reversals have maintained their down trend.
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[li]Carry Trade Gains As Yields Turn Higher, Global Growth Outlook Improving [/li][li]Fed Boosts Liquidity Even As Demand Fades [/li][li]Market Condition Indicators Improve As Risk Returns For Most Assets [/ul] The global credit crunch seems to be loosing its grip on the financial markets; and in its place, improving liquidity levels and growth outlook have revived a taste for risk. For the currency market, the appetite for yield boosted the DailyFX Carry Trade Index $123 to $29,020 and extended a modest yet steady advance for the basket. What’s more, with this past week’s strength, the market seems to have pushed through resistance in a descending trend channel that has guided carry lower since the subprime meltdown last summer. Alongside the improvement in price action, market activity indicators similarly improved. The DailyFX Volatility Index edged closer to the 10 percent-mark as fears of major capital losses ease. At the same time the directional risk reversals have maintained their down trend.[/li]
Markets are showing the tell-tale signs that central banks’ efforts to restore liquidity to the frozen credit market are paying off. Over the past few weeks, demand for stocks and commercial and government debt has pulled each asset class out of steep declines that have guided price action since the second half of last year. In turn, volatility has settled; and sidelined capital is finding its way back into high-yielding and risk-sensitive assets. Adding to the positive outlook for investment conditions were the outlook for interest rates and growth in the US. The revision of the first quarter GDP figure boosted speculation that the world’s largest economy would avoid a recession and thereby revive global growth. In turn, futures show the market believes the FOMC may begin raising rates later this year and restore returns. The Fed’s efforts to insure liquidity to the markets seems to further these expectations. The policy group announced three more $75 billion TAF infusions in June even as a $25 billion auction to investment firms on Thursday received only $16.4 in bids.
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[B]Risk Indicators:[/B]
[B]Definitions[/B]:
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
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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.
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, Currency Analyst for DailyFX.com
Questions? Comments? Email John at <[email protected]> to discuss this or other articles he has authored.[/I]