Economic and financial conditions are worsening. And, despite the global effort to stabilize markets and revive growth, it is only a matter time before feeble optimism gives way to fear once again. Indications of building strains are visible in economics, market operations and certainly price. Looking at the market’s more traditional asset classes, the sense of risk aversion is unmistakable.
• Mounting Strains In Global Financial Markets Threaten To Topple Government’s Efforts To Revive Sentiment
• Nationalizing Major Financial Firms And Need For Emergency Aid In Eastern Europe Reveals Desperate Circumstances
• Another Wave Of Interest Rate Cuts Highlights The RBA’s Decision To Pass
Economic and financial conditions are worsening. And, despite the global effort to stabilize markets and revive growth, it is only a matter time before feeble optimism gives way to fear once again. Indications of building strains are visible in economics, market operations and certainly price. Looking at the market’s more traditional asset classes, the sense of risk aversion is unmistakable. The FTSE 100 has closed pushed to six year lows, the Dow Jones Industrial Average has outpaced its slump in the great depression to close for 12 year lows and the Nikkei 225 is just off of levels not seen in over a quarter of a century. However, there is a reserve to these declines as investors hold back from fully divesting themselves. This endurance cannot hold up though should the signs of systemic risk build. World-wide, treasury prices are forging new highs, default protection on corporate debt is pushing records and liquidity is prized as a safe haven quality over traditional notions of what is risk free. This is what he have seen in the currency market. Once the most prominent funding currency and refuge in times of uncertainty, the Japanese yen has been unseated by skeptical markets. And, as the market tries to discern the risk laden currencies from the risk free with interest rates deflated, we have seen the Carry Trade Index left to chop. Nevertheless, the ultimate break will genuinely reflect the true sentiment of the crowd.
Despite their best efforts, governments are fighting trends in economics and investor sentiment that perhaps cannot be artificially curbed. Starting with the global recession; there is little doubt from market participants or policy officials that the world wide economy is on pace to suffer a far worse contraction through the first half of this year than what has been confirmed through the end of 2008. This translates into rising unemployment, a surge in bankruptcies and defaults, and a plunge in consumer spending which naturally reduces potential returns and the availability of credit. With the threat of a global depression at hand, we have seen policy makers take increasingly drastic steps to rescue their own economies. Stimulus packages have ballooned for the US, Germany, UK, Japan and others. Taking the last steps available to them through traditional policy channels, central banks issued another round of rate cuts this past week – leaving some boards looking at quantitative easing as the next option. Perhaps the most controversial move though is the trend towards nationalization. This is a last resort for any free-market economy; and though only a very few deals have been defined as such, their presence is growing (Lloyd’s, Citi, AIG, etc). Looking ahead, there are two major events that look as if they could fundamentally shift sentiment: the potential collapse of some Eastern European economies and the G20 meeting in early April. From the latter, a plan to address the global impact of the economic and financial crisis may genuinely turn things around.
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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 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]>.