The high end of the yield curve has taken a significant hit over the past week; and carry trades have suffered the consequences. The DailyFX Carry Trade Index sunk $298 dollars since last Friday after failing to over take a descending trendline that has been directing the basket since risk appetite was tripped up by the subprime meltdown last summer. In turn, a breakdown in USDJPY and other yen crosses has weighed on risk reversals, which show a greater demand for puts. However, during this reversal, the outlook for a BoJ hike over the coming year has eased and volatility cooled, suggesting this will be a more orderly (and perhaps short-lived) carry unwind.
· Massive Bank Losses And Write Downs Drag Risk Appetite And Carry Lower
· Fed Increases Its Bi-Weekly TAF Auctions And Broadens Acceptable Collateral
· High Yield Currencies Plunge Across The Board As Economic Conditions Dim
The high end of the yield curve has taken a significant hit over the past week; and carry trades have suffered the consequences. The DailyFX Carry Trade Index sunk $298 dollars since last Friday after failing to over take a descending trendline that has been directing the basket since risk appetite was tripped up by the subprime meltdown last summer. In turn, a breakdown in USDJPY and other yen crosses has weighed on risk reversals, which show a greater demand for puts. However, during this reversal, the outlook for a BoJ hike over the coming year has eased and volatility cooled, suggesting this will be a more orderly (and perhaps short-lived) carry unwind.
There were few market factors working in carry’s favor this past week. The most prominent element to the strategy’s performance came towards the end of the week when major financial firms Citigroup and AIG announced considerable losses and write downs. Perhaps taking the SEC’s new policy for companies to disclose their liquidity and capital positions to revive confidence in the financial markets, Citi took the unprecedented move of announcing plans to sell $100 billion in non-core businesses and $400 billion in low-yielding assets over the next few years to boost its capital position. This ‘write down’ accounts for more than 20 percent of the entire company. Another major weight on the carry basket came from a series of bad data from the high yielders. The most significant hit came from the New Zealand employment number, which dropped the most in 19-years. Amidst this heavy-handed data however, the Fed was once again the silver lining. The policy authority announced it would expand its TAF auctions from $50 to $75 billion and accept asset-backed debt.
[I]Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum[/I]
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[B]Risk Indicators:[/B]
[B]Definitions[/B]:
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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 are greater for puts than for calls (as implied volatility for puts is quoted as a negative percentage and implied volatility for calls is quoted as a positive percentage) and traders are expecting the pair to fall; and visa versa.
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[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.