The sharp rally that opened this week seemed to confirm that the next wave of a five-month bull trend was underway. However, this optimistic outlook was immediately deflated when momentum failed support the transition. What is the source of this hesitation? Fundamentals.
• Dollar Makes a Critical Bearish Break but Risk Appetite Provides Little Follow Through
• Sentiment-based Momentum Giving Way to Judicious Fundamentals
• Monetary Policy Efforts Reveals a Building Divergence in Growth and Inflation Forecasts
The sharp rally that opened this week seemed to confirm that the next wave of a five-month bull trend was underway. However, this optimistic outlook was immediately deflated when momentum failed support the transition. What is the source of this hesitation? Fundamentals. Risk appetite and broad economic growth are two separate conditions. Generally, the former follows the latter; but when speculation is involved, inconsistencies often arise. Tracking sentiment since the beginning of the year, we have seen a clear evolution from a market that was attempting to establish stability after a financial crisis to one that was expanding as idle capital returned and yield forecasts rose. At this point, the reversal is unmistakable; but then again, this does not mean it is permanent. The more traditional asset classes have cleared their highs for the year; but the drive behind this rally has certainly eased. Equities, represented by the Dow Jones Industrial Average, have stalled over the past three days. In a similar fashion, the speculative-receptive commodities market has pulled back from its own highs without a clear level of resistance overhead. Alone, these asset classes would suggest risk appetite is health, just taking a breather. However, in the currency market, the conflict is more obvious. Looking beyond the 10-month high for the carry index itself, we have seen the US-dollar based majors stall immediately after mark-wide break against the greenback. And, ensuring that this is not just the dollar break from sentiment, the yen crosses have themselves yielded ceded to resistance.
Looking at the market’s as a whole, we are left to believe that a recovery is well under way. However, the developing trend behind investments is as assured as the revival of growth – that is to say, it is still highly uncertain. It is important to separate the influences of sentiment from the true foundation of economic expansion. Clearly, data over the past half year has supported the notion that the worst of the global recession is likely past and perhaps that positive growth is on the horizon. Coming from a record-breaking recession and ongoing financial crisis, this turn would naturally bolster confidence. A sense of stability is certainly enough to draw sidelined capital back into market-based assets (and thereby inflate their values); but to promote a true bull wave, turnover has to be catalyzed by the promise of rising returns and tangible growth has to produce wealth. The global economy has not yet graduated to this phase. Growth readings to this point have merely reported a moderation in the pace of the ongoing recession. Officials from many of the world’s largest economies see expansion at or after the turn of the year. Yet, even if this milestone is reached, growth from that point is forecasted to stagnate. To this point, government spending and stimulus has been the primary engine for improvement. Policy makers may be able to keep this scaffolding in place long enough for lending to fully thaw and business investment to revive; but the consumer is the key in this equation. Now the question becomes whether those countries with positive growth (China, Australia) will fold under the pressure.
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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]>.