Measuring volatility has been the primary occupation of traders and other market participants this past week. Currencies, equities, fixed income and nearly every other major asset class have experienced dramatic swings through a clearly low liquidity period; but the same subconscious questions are claiming responsibility for direction.
• Like the Markets, Risk Appetite Exudes Volatility but Lacks Direction
• Growth Forecasts are Turning Positive, But How Optimistic Should We Be?
• Policy Officials Shouldn’t Treat Financial Markets as if Conditions are Back to Normal
Measuring volatility has been the primary occupation of traders and other market participants this past week. Currencies, equities, fixed income and nearly every other major asset class have experienced dramatic swings through a clearly low liquidity period; but the same subconscious questions are claiming responsibility for direction. What will the pace of the recovery be through the end of the year and beyond; and are financial markets healthy enough to support a sustained influx of capital while offering greater rates of return in the meantime. Considering the market’s progress this past week, confidence found yet another fundamental setback in its steady recovery through much of this year. For the equities market, price action was exceedingly volatile; but the world’s benchmark indices were struggling to make progress (whether it be further rallies or meaningful retracements). The S&P 500 has not ventured far from its 15 point range in nearly three weeks. This could be considered just another pause (like the one in early June); but a look at the steadily diminishing volume behind the this, and other indices’, advance suggest confidence in the sustainability of this market recovery is as fragile as that of the economy. For currencies, risk appetite was stalled and therefore so to was carry interest. With a break in the steady stream of moderately bullish data to support yield forecasts, long-term considerations were weighing on speculation. Taking a big-picture view of this deeply liquid market’s health, it is clear that while volatility readings and yields (risk and reward) are improving, they are far from pre-crisis ‘normal.’ What’s more, the drop in investment has lowered FX trade volumes by nearly a fifth through April.
It is the best time to take an unbiased assessment of the market’s health when conditions stabilize and speculative interests are not being pandered to. Volatility was extraordinarily high this past week; but the stalled market trends provided an opportunity to analyze the fundamentals behind risk premiums and optimistic forecasts. There were certainly promising signs. Offering few surprises; but supplying a welcomed confirmation, the IMF said the global economic recovery was indeed under way – adding its unique, international estimation to national politicians whose job it is to be a cheer-leader for their individual countries. Elsewhere, credit conditions continued their steady trend towards normalcy as the TED Spread (the difference between 3 month Libor rates and their government T-Bill counterparts used to measure credit risk) fell to its lowest levels since before the currency crisis began back in the middle of 2007. These are promising signs, no doubt; but they are not definite signs of the next aggressive period of expansion and bull market rally. Qualifications for economic improvement are based compared to the plunge into the severe recession of 2008/2009. The popular consensus among market participants, economists and policy officials is that growth will suffer a period of stagnation. The same is true of the markets. Liquidity may be ample for banks; but defaults are rising, wealth is shrinking and toxic debt is still out there.
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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.
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[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]