Like the underling markets, risk appetite was exhibiting high levels of volatility this past week without making true progress. Nonetheless, carry interest and many of the other speculative asset classes are just off of their highest levels for the year. However, as this market recovery matures, the scrutiny over the fundamental drive behind this move will increase.
• Risk Appetite Hits New Highs For the Year, How High Can It Go?
• Growth Outlook Improves, But is it the Level of Expansion to Support Yields?
• Financial and Credit Conditions Improving But Stimulus Exit Strategy Focused on Growth
Like the underling markets, risk appetite was exhibiting high levels of volatility this past week without making true progress. Nonetheless, carry interest and many of the other speculative asset classes are just off of their highest levels for the year. However, as this market recovery matures, the scrutiny over the fundamental drive behind this move will increase. And, while a perfunctory look at the better-than-expected GDP readings and downtick in the US unemployment rate these past few weeks may seem the perfect catalyst for sure-footed bull trend, the outlook for risk and reward is much more complicated than that. Taking stock of the general level and health of the markets, momentum looks fully supportive of a steady rise in risk appetite. From investors’ traditional market of choice, the S&P 500 has been stuck in a range for the past two week; but the ceiling on this congestion happens to mark the highest level for the index in 10 months. However, it is notable that this advance has developed on a steady decline in volume since the March reversal. This offers a unique insight that currency traders aren’t privy to due to the lack of accurate volume data. As for the FX world, risk-sensitive currencies have maintained their trajectory; but conviction has waned over the past week. Whether this is a hiccup or the making of a reversal, it is too early to tell. Yet, looking at the underlying measures of expected return and volatility for this liquid asset class, the elements for a recovery seem to be there as volatility hits lows not seen since before Lehman and yield forecasts rise.
A good balance of risk and reward is the essential measure for each trade; but it is also the foundation for sentiment and investment flows for the broader market. This is what needs to be kept in mind when considering whether we are entering a long-term bull wave for the global economy and markets. Over the past week, the data and official forecasts that have been releases have offered additional fuel to the claim that we are indeed heading towards a sustainable recovery. From the US – the world’s largest economy – the monthly non-farm payrolls (NFP) report supported the smaller than expected contraction in second quarter GDP reported the previous Friday with the first downtick in the unemployment rate since April of 2008. Optimism was furthered with the surprising expansion in the Euro Zone’s two largest members – Germany and France. These are just a few of the early signs that the global economy is indeed recovering from its worst slump since the Great Depression. However, a tempered recession – and even a return to positive growth – does not ensure the next market phase. Without a recovery in employment and consumer demand, the economy will stagnate after government support is withdrawn. Eventually, speculation will have come to the point that it has overshot the true, sluggish pace of growth and the premium will be deflated. However, due to the influx of sidelined funds this may not happen until the fourth quarter. In the meantime, there are still lingering issues with toxic debt on government balance sheets and the need to reduce government deficits.
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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 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.
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]>.