It has been an eventful week for the capital markets. With the return of liquidity, we have seen the trend in risk appetite extend its advance (and the dollar inversely maintain its bearish trajectory). New highs for the year in carry interest, equity benchmarks and EURSUD is clear evidence that fear continues to dissipate and the demand for yield is steadily growing. However, you can’t point out these bullish signs without also noticing the fading momentum behind the advance.
• Risk Appetite Buoyant in Currencies and Stocks, Yet Momentum Still Lacks Across the Board
• Policy Authorities Vow to Keep Rates Depressed for the Foreseeable Future
• Is the Dollar the New Funding Currency for a Quickly Recovering Carry Trade?
It has been an eventful week for the capital markets. With the return of liquidity, we have seen the trend in risk appetite extend its advance (and the dollar inversely maintain its bearish trajectory). New highs for the year in carry interest, equity benchmarks and EURSUD is clear evidence that fear continues to dissipate and the demand for yield is steadily growing. However, you can’t point out these bullish signs without also noticing the fading momentum behind the advance. How long will can optimism outrun fundamentals; and more importantly, which will be the first to submit. Looking at the market’s without reference to the background data, easy to argue that the recovery is on solid ground. The reversal from lows set back in March was universal and we have seen few – if any – significant corrections on the way up. New highs for the year have been a frequently quoted statistic for some time now; and it can once again be used for this past week. On the other hand, we have seen the progress on each subsequent marking less progress before it is winded. Though difficult to measure, conviction in the advance is fading as investors grow increasingly hesitant to enter the market with so many asset classes already 20 to 30 percent off their recent lows. Perhaps the most definitive gauge of confidence is the volume data on equities. Since the benchmark Dow Jones Industrial Average began its upswing in earnings, interest in the rally has faded. Of course, there is a lot of sidelined capital in Treasuries, money markets and other relatively risk-free assets that can continue to feed the speculative rally; but eventually, risk will outrun the reasonable expectation of returns and the tap for capital will be turned off.
Gauging whether the steady advance in risk appetite will break is a matter of timing. If the draw of capital gains can hold market participants’ attention long enough for the fundamental outlook to improve and yields to match expectations, then the pressure for a correction will dissipate (this is not to mean there wouldn’t be a pull back – it would simply be less dramatic). On the other hand, if the recovery in growth and yields is to be as measured as so many policy officials have forecasted, then sentiment would be condemned to a rectification to economic reality that could severely alter the trading landscape. Lightening the scene this past week, all three major central bank decisions were considered to hold take on a hawkish tinge from previous months. The Bank of England held its quantitative easing program steady at 175 billion pounds, the RBNZ removed commentary that kept the door open for further rate cuts and the Bank of Canada statement noted that growth through the second half of the year would likely be stronger than was allowed for in July. However, it is important to step back at the bigger picture and note that each group has explicitly stated plans to keep their respective benchmark lending rates at their excessively low levels until at least the middle of next year. And, this isn’t just a stance that these three are taking; but it is used amongst most investment destinations. It is noteworthy, that policy groups often wait well after unemployment peaks before pursing rate hikes (the Fed waited for nearly a year after each of the last two recessions). What’s more, investors may sabotage themselves. Leverage in the capital markets has quickly returned to pre-crisis levels even as defaults hit recent record highs.
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[B]Risk Indicators:[/B]
[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.
[B]Additional Information
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]