Risk appetite has diminished for months; yet the positive bias behind the capital markets has not faltered whilst traders sought out the fundamental fuel for the next trend. However, we may see a resolution on both the direction and intensity of sentiment soon as the technical and fundamental pressures build to a breaking point behind the scenes.
• Currency Market and Risk Appetite will Rediscover Volatility and Direction Soon
• How does Thin Liquidity Effect the Market? What about the Return to Normalcy?
• A Gradual Return to Growth may not Support a Bullish Market
Risk appetite has diminished for months; yet the positive bias behind the capital markets has not faltered whilst traders sought out the fundamental fuel for the next trend. However, we may see a resolution on both the direction and intensity of sentiment soon as the technical and fundamental pressures build to a breaking point behind the scenes. Whether in the FX, stock, fixed income or any other speculative market; liquidity is acting as a dampener for price action. The height of the summer holiday season has drained the markets and the extended US holiday this coming week will certainly exacerbate the situation. Under such unusual circumstances, volatility can be artificially inflated; but news and meaningful trends are very difficult to establish. As the trading ranks begins to fill out once again next week, the technical congestion that has developed around the most liquid currency pairs will lead to breakouts. What’s more, with both the dollar-based Majors and the Japanese yen crosses in the same position; a break will likely be echoed across the market and further fuel an shift in sentiment itself. EURUSD would be an appropriate gauge for any new trends that develop. The most actively traded currency pair is not highly sensitive to risk appetite; but that works in our favor as it will follow a trend rather than mere volatility. For motivation, three months of congestion has turned into a terminal congestion pattern and the average true range (with a 10-day average) has fallen to its lowest level since February of 2008. A break is inevitable; but the next trend will likely rely on fundamentals.
While it isn’t necessary, we can point out more than a few catalysts that can reasonably revive sentiment trends. The most pressing indicator on deck is the US labor data. The non-farm payrolls (NFP) report is awell-known market mover. Furthermore, liquidity will be extraordinarily low for the event due to the US Labor Day holiday; and these warped conditions could easily leverage a response to an unexpected release. On the other hand, thin markets are not conducive to trends and momentum. Beyond this single event, there is also the G-20 meeting in London. This is a gathering of financial ministers which will look to establish framework for two, heavily discussed topics as of late: regulation and exit plans. European ministers have taken a unified stance that is calling for global limits on bank size and compensation. This is a longer-term concern and one that could ultimately be ignored as the markets show a tentative recovery at the risk of forming the next financial bubble. The more immediate concern is developing viable strategies to remove stimulus from the markets and more importantly the timing for such an endeavor. Policy agreements will likely be reached until the official September 24/25 meeting in Pittsburgh; but the rules drafted in the forthcoming gathering will likely be the end result. Despite these efforts though, the market’s direction will ultimately be decided by speculators. A six month advance in optimism has clearly outpaced fundamentals; and its isn’t likely that the latter will catch up to the former. Interest rate leaders (the ECB and RBA) have taken telegraphed a neutral stance and the OECD has said the global economy’s return to normal will be “protracted and slow.”
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[B]Definitions[/B]:
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[B]What is the DailyFX Volatility Index: [/B]
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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 and traders are expecting the pair to fall; and visa versa.
We use risk reversals on USDJPY as global interest are bottoming after having fallen substantially over the past year or more. Both the US and Japanese benchmark lending rates are near zero and expected to remain there until at least the middle of 2010. This attributes level of stability to this pairs options that better allows it to follow investment trends. When Risk Reversals move to a negative extreme, it typically reflects a demand for safety of funds - an unfavorable condition for carry.
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[B]How are Rate Expectations calculated:[/B]
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Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe market prices influence 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 Reserve Bank of Australia (RBA) will make over the coming 12 months. We have chosen the RBA as the Australian dollar is one of few currencies, still considered a high yielders.
To read this chart, any positive number represents an expected firming in the Australian 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 increase and carry trades return improves.
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.
Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at <[email protected]>.