The late rebound in the US dollar and sharp pull back in volatile crude helped revive the ailing carry trade this past week. However, considering the deteriorating outlook for the US financial system and the fading yield outlook, it may be difficult to sustain the fickle market conditions needed for the carry trade to prosper.
• Dollar Rally And Crude Pull Back Salvages A Carry Collapse
• Can Risk Appetite Continue To Rise With Freddie, Fannie And Lehman Facing Collapse?
• Rate Forecasts Continue To Cut Into Returns Regardless Of Risk
The late rebound in the US dollar and sharp pull back in volatile crude helped revive the ailing carry trade this past week. However, considering the deteriorating outlook for the US financial system and the fading yield outlook, it may be difficult to sustain the fickle market conditions needed for the carry trade to prosper. With the week’s rebound, the DailyFX Carry Trade Index rose 120 points (less than 15 percent of the steep reversal from July 22nd). However, while the bounce has been slow to gain ground, market conditions have benefited from the reduced momentum and volatility. The DailyFX Volatility Index fell 0.3 percentage points to 10 percent as many of the majors settled back towards major dollar-resistance levels. What’s more, risk reversals for the proxy carry pair (USDJPY) show traders are once again paying a higher premium for directional calls and less for protective puts – an indication of risk and direction.
It shouldn’t be a surprise that the rebound in the carry trade has proceeded rather cautiously. Fundamentals surrounding the appetite for yield and aversion to risk have clearly shrouding the future of the global financial sector in a disappointing light. The top headlines over the past week show a market that is growing increasingly fearful of another major financial collapse on the level of Bear Stearns. Further whipping up speculation that such an event was inevitable, the former head of the IMF forecasted that at least one major American bank would go under within the year. So, who could end up take such an nefarious title? The candidate pool is deep. Citi recently recently downgraded its profit outlook for Goldman Sachs, Lehman Brother and Morgan Stanley (and many others are joining the list with forced buy backs of auction rate debt adding to already damaging write downs). However, there are a number of banks that are on a watch list, many analysts and market participants see a particular set of banks circling the drain. Freddie Mac and Fannie Mae debt yields jump to its highest level since 1986 while its preferred shares were slashed to the lowest investment grade. Elsewhere, Lehman brothers is holding an estimated $75 billion in hard to sell assets and failed to move 50% of a share offer in Asian.
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[B]Risk Indicators:[/B]
[B]Definitions[/B]:
[B]
DailyFX Volatility Index[/B]
[B]What is the DailyFX Volatility Index: [/B]
[B][/B]
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.
[B][/B]
[B]USDJPY 25 Delta Risk Reversals 3 Month[/B]
[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 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.
[B][/B]
[B]Bank of Japan Rate Expectations[/B]
[B]How are Rate Expectations calculated:[/B]
[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.
Written by: John Kicklighter, Currency Strategist for DailyFX.com
Questions or comments on this or other articles John authors? You can email him at <[email protected]>.