Months ago, policy markers were desperately trying to curb fears of a financial crash with sharp interest rate cuts and massive bailouts. And, while the haze of panic may have dissipated with time, risk appetite continues to suffer from burgeoning recessions, falling interest rates and government reforms that smack of nationalization.
• Markets And Sentiment Testing New Lows Despite Policy Makers Efforts
• Investors See A New Threat In Nationalization
• Interest Rate Cuts Next Week Look To Raise The Risk/Reward Water Mark
Months ago, policy markers were desperately trying to curb fears of a financial crash with sharp interest rate cuts and massive bailouts. And, while the haze of panic may have dissipated with time, risk appetite continues to suffer from burgeoning recessions, falling interest rates and government reforms that smack of nationalization. Looking to the markets and their respective conditions gauges, there was a disputable week-over-week improvement. For the currency market, the Carry Trade Index notched a modest improvement; but the bigger picture shows the barometer for sentiment trending steadily towards an eventual plunge. It isn’t difficult to find confirmation for the descending wedge formation from this index among the individual currencies and pairs. Perhaps the most convincing evidence that sentiment in the FX market is on the verge of another plunge is the state of the US dollar. Over the past few weeks, we have seen the world’s most liquid currency take the role of top safe haven. With the Dollar Index pressing three-year highs, it is clear that capital preservation is driving traders away from risk. A similar mood is felt within the other speculative asset classes. The S&P 500 close the week at a 12-year low, junk bond spreads are trending higher and the CRB commodity index is just off multi-year lows. This may seem to contradict improvements in volatility and other conditions reports; but risk is always valued against the potential for return.
To truly gauge the health of risk appetite in the financial markets requires a fundamental understanding of the potential for risk and reward rather than merely looking at changes from one period to the next. For example, the recent improvement in options’ pricing, volatility readings, and credit risk premiums can be attributed to a recovery in stability that has allowed the markets to more or less function normally. However, merely having a normally functioning market does not automatically translate into optimism and a demand for yield. Looking at basic economic data, the probability that returns will continue to shrink as global activity is shrinking is high. This past week we have seen the US, UK and Euro Zone confirm dire recessions; and forecasts ranging from official to speculative are pretty consistent in predicting worse to come. Add to this a steady decline in global lending rates (the ECB, BoE, BoC and RBA are all expected to cut next week) and the foundation for returns is slipping. Further upsetting the simple balance of risk and return, we now see that specter of nationalization could dampen a recovery in investor confidence even longer. In policy officials’ eagerness to curb financial turbulence and turn growth around, they have gone so far as to seize ownership of key financial players. Not only does this lead to massive deficits and stoke fear that many more firms on the verge of collapse, it also hampers the industry’s eventual recovery as the government determines the pace of investment by erring on the side of excessive caution.
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[B]Risk Indicators:[/B]
[B]Definitions[/B]:
[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 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.
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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]>.