While all eyes were on the US dollar’s major breakout effort towards the end of this past week, a look away from the majors revealed another major currency market trend change: the breakdown in the carry trade. By Friday’s close, the DailyFX Carry Trade Index closed at 27,954 after a 571 plunge from last week which brought the basket to its lowest level since April 14th.
[B]• US Dollar Rally Masks A Severe Carry Breakdown
• Concerns Over Liquidity And Lending Continue To Play Credit Market
• Can The USDJPY Lead A Carry Rebound, Or Is Doomed To The Same Fate As Carry?[/B]
While all eyes were on the US dollar’s major breakout effort towards the end of this past week, a look away from the majors revealed another major currency market trend change: the breakdown in the carry trade. By Friday’s close, the DailyFX Carry Trade Index closed at 27,954 after a 571 plunge from last week which brought the basket to its lowest level since April 14th. This sharp reversal officially curbed any speculation that demand for interest rate differentials could push to new highs while risk appetite faded and the potential for returns faded. Not surprisingly, the supplementary data we monitor has deteriorated along with the drop in carry. Action in the currency market drove the DailyFX Volatility Index back above the closely watched 10 percent level. At the same time risk reversals have still favored calls and seemingly beneficial USDJPY bullishness. However, this is a fundamental anomaly.
Aside from the USDJPY’s advance this past week, almost every other carry sensitive pair plummeted (thereby driving the Carry Index down). This setback for the popular income strategy is not surprising considering the evolution of fundamentals and market conditions over the past few weeks (and months). Impacting trends just this past few days, Moody’s warned that it was forecasting 10 percent of borrowers in speculative grade bonds would default over the coming year – putting not only liquidity in jeopardy, but severely reducing the risk of returns for carry and basic lending. Elsewhere, Fannie Mae reported it would be increasing fees, reduce its high risk mortgage buying and charge higher risk premiums – reducing the available pool of capital and reducing the safety net the popular GSE offered to the market. Another concerning announcement was the joint report from a number of major banks (JP Morgan, Merrill Lynch, Citi, HSBC, Lehman, among others). They suggested a willingness to invest in technology and risk management, bring their structured products into view of regulators and allow only the most wealthy and savvy individuals invest in the hard hit derivatives – a prominent sign that they are afraid conditions could become much worse.
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
[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 it is the benchmark yen pair and the Japanese currency is considered the proxy funding currency for carry trader. When Risk Reversals grow more extreme to the downside, there is greater expectations for the yen to gain – an unfavorable condition for carry trades.
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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 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.
[B]Additional Information[/B]
[B]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.