Risk appetite across the markets has maintained the bullish trajectory cultivated since the beginning of March; but momentum has clearly drained over the past few weeks. The hesitation develops as market participants debate the merits of forecasting a genuine market recovery on the basis of what is so far early signs of a moderating recession and the promise such tentative progress holds for bolstering yields.
• Market Sentiment and Carry Interest Will Have To Find Its Bearings Soon
• US and New Zealand Credit Ratings Shirk Dour Forecasts
• A Round of Rate Decisions and Growth Reports Gauge Risk/Reward
Risk appetite across the markets has maintained the bullish trajectory cultivated since the beginning of March; but momentum has clearly drained over the past few weeks. The hesitation develops as market participants debate the merits of forecasting a genuine market recovery on the basis of what is so far early signs of a moderating recession and the promise such tentative progress holds for bolstering yields. This wavering is a sign that skepticism is on the rise with traders having already spent much of the fuel a speculative rebound could afford the market after a lengthy period of caution and deleveraging. However, looking at the Carry Trade Index, it is clear that this congestion will come to a breaking point soon. Looking beyond the congestion of the past month, there is still a steady bullish bias behind risk appetite since February. The same can be seen in the benchmarks for the various markets: the S&P 500 has advanced eight out of the past 10 weeks; the benchmark 10-year Treasury note is off nearly 9 percent from its record highs set in December; and AUDJPY has climbed 12 of the past 16 weeks to a current perch of 33.5 percent off its recent record lows. Clearly, the momentum of these past few months would support a continued rise in sentiment. However, putting this advance into perspective, the Carry index is still more than 26 percent off its 2006 highs and equities are more than 40 percent from their respective record highs.
When will the struggle between speculation and fundamentals balance out; and what will happen when the market shifts back to this equilibrium? As the market’s appetite for risk rises, we have to consider what can fuel the advance through the coming days, weeks and months on to a genuine recovery – if this is indeed a genuine recovery. Here we see objective fundamentals are still sketchy in their support for a rise in optimism. Taking the basic ‘risk-versus-reward’ analysis approach, there is reason to be concerned over further financial troubles later down the line and certainly grounds to doubt a rise in returns beyond what volatile speculative gains can achieve. Separating capital returns and yield income is essential. Capital gains can be driven by normal market forces like a rebound from oversold conditions and temporary momentum to sustain a rally as investors return to the market. This could essentially be the foundation for the progress we have seen the markets make over the past three to four months. However, to turn a reversal into a recovery, there needs to be the hope of higher yield income to attractive deeper pools of money to the more established carry trade interests. Next week’s RBA, ECB, BoE and BoC rate decisions will help on this front. Should they all hold as expected and note improvements seen in the distance, we will be one step closer to a return to carry. In the meantime, safety is still the greater unknown. While the US and New Zealand debt ratings were recently secured, we still have not seen a clear turn in global recession readings.
[B]Risk Indicators:[/B] [B]Definitions[/B]: [B] [/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][/B] [B][/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 AUDUSD as global interest rates have quickly fallen towards zero and the lines between safe haven and yield provided has become blurred. Australia has a historically high and responsive benchmark, making it more sensitive to current market conditions. When Risk Reversals grow more extreme to the downside, it typically reflects a demand for safety of funds - an unfavorable condition for carry. [B][/B] [B][/B] [B][/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 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.
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 <firstname.lastname@example.org>.