Currency Market Bull Trend Stalling as Growth Forecast and Financial Stability Loose

High volatility has carried over from last week owing largely to low levels of liquidity that amplify intraday market swings. However, despite the high level of activity in the market, direction is still a missing vital component of the long-term bull trend that investors have steadily funded since the reversal in risk appetite back in March. Once again, the question of whether the past six months have represented a genuine bull market or merely a bear market retracement is being posed.

• Currency Market Bull Trend Stalling as Growth Forecast and Financial Stability Loose Traction
• Will Bullish Speculation Relent to a more Bearish Fundamental Outlook?
Fed Ruling May Test Investors Confidence in Market Stability

High volatility has carried over from last week owing largely to low levels of liquidity that amplify intraday market swings. However, despite the high level of activity in the market, direction is still a missing vital component of the long-term bull trend that investors have steadily funded since the reversal in risk appetite back in March. Once again, the question of whether the past six months have represented a genuine bull market or merely a bear market retracement is being posed. Eventually, genuine fundamentals and the sedate forecasts they project will have to be reconciled with the steady rise in investor sentiment; and at these levels it is increasingly clear which is growing overextended. Most capital markets have shown an unbroken, bullish bias that has retraced a significant portion of the unprecedented losses through the 2007-2008 financial crisis. For the popular equities market, the benchmark Dow Jones Industrial Average has advanced nearly 50 percent from its lows in the first quarter. What’s more, the index has risen for every one of the last eight sessions. Yet, thanks to easily compiled volume data, we can see that the conviction behind this move has become severely taxed. Not only has the general investment in this market cycle started to deteriorate since it began; but the weekly average has fallen to its lowest levels for the year. For the FX market, the progress of risk appetite is reflected in the performance of high potential currencies against those that are stationary or deteriorating (as measured by yield). Both the dollar and Japanese yen have developed relative levels of support over the past weeks against counterparts like the euro, Australian and New Zealand dollar.

While congestion has become a common sight across the markets, it is clear that the general bias is still positive. Speculative interests are well supported – especially with a considerable portion of the market’s investable capital still held in relatively ‘risk-free’ securities like Treasuries and money market accounts. Nonetheless, the influx of capital cannot be sustained on capital appreciation alone. Eventually, the profit potential in investing in an oversold market will dry up as demand for return quickly overwhelms the yield that the global markets can support. Just when will this shift happen is a matter of significant debate. Policy officials have carefully articulated their forecasts for growth by suggesting an initial recovery from the worst recession since WWII will be followed by a period of weak expansion. Naturally, this is not the type of markets that wealth and yields grow in. What we await now is a catalyst to align the markets to fundamentals. The most immediate threat is the recent ruling by a US court that the Federal Reserve must release the details it has on hand of its emergency lending programs (with names and amounts) by August 31st. While this ruling can be appealed and delayed; it could still unsettle confidence in the credit markets and fuel fears of another wave of runs on banks (the kind that led to the collapse of Bear Sterns and Lehman Brothers). Even if this threat never materializes, there are still many other active hazards. Recently, the FDIC reported the number of troubled banks rose to a 15-year high 416. The market cannot support issues like this for very long.

                                      [B]Risk Indicators:[/B]

                                   [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. 

[B]Additional Information[/B]

[B]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.

[B]Carry Trade As A Strategy[/B]
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 Strategist for DailyFX.com.
Questions? Comments? You can send them to John at <[email protected]>.[/I]