Recently carry trades, global equities and commodities have all stumbled onto the chopping block. If this market-wide sell off looks familiar, it should. This is the same sort of highly correlated move that swept the markets back in July and August. Given the sizable moves racked up in all of the pertinent assets over this past week, comparisons were bound to be drawn between then and now.
What most market participants are eager to know is whether this is yet another pull back offering good buying opportunities or the true turn in the market. For currency traders, this question could define trends in direct carry trades (like the yen crosses) and possibly even the US dollar. So, to understand conditions this time around, it is important to examine what happened in August.
[B]The August Slump[/B]
Broad risk trends have seen incredible volatility over the past four months as a US-centric subprime mortgage problem has evolved into a full blown, global credit crunch. While many market participants had followed the slow descent of the American housing market into its current recession, few had expected the troubles to breach the boundaries of the isolated sector – much less the country. However, all of that changed in late July. Risk aversion slowly started to perk up on July 20th after an Australian hedge fund wrote down the value of its US residential mortgage-backed securities. From there, a number of hedge funds succumbed to the building credit crunch (see the map below). And, in an unprecedented move, on August 9th, in response to seizing credit markets, the ECB injected 94.8 billion euros into the market in an attempt to calm the sudden demand for cash on hand. This market aid triggered preceded a trend of major central banks infusing the market with cash. However, these efforts were clearly ineffective as declines in global equities and carry traders actually accelerated. It wasn’t until August 17th, when the Federal Open Market Committee announced a 50 basis point reduction to its discount rate that the worries began to alleviate. After this unusual move, risk appetite and carry trades started to creep back up. Hesitancy in this budding rebound was washed away on September 18th when the Fed followed up with a 50 basis point cut to both its Federal Funds and discount rate.
[B]The Recovery[/B]
Since the world-wide effort to restore order was made, many of the markets have gone on to recapture their previous highs while others have marked new records. In the commodities world, the increasingly speculative crude oil and gold investments have marked a record and 27 year high respectively. Global equities traced out similar rebounds: the Hang Seng soared to new heights: the S&P 500 Index in the US rallied to a fresh record through October; and the MSCI World Index topped 4,000 for the first time last month. However, not all markets shared the same exuberant return to optimism. Interest rate markets retained permanent scars from the credit crunch over July and August. In fact, the spread between the risk-free 3 month Treasury bill rate and the LIBOR rate with the same maturity (a standard measure of risk tolerance) has retained a significant risk premium since the Fed cut rates (see the graph below). The popular carry trade – also based on interest rates – similarly failed to regain its highs. The EURJPY was over 100 points away from its July highs, NZDJPY was petered out with more than 600 points to go and GBPJPY came up nearly a thousand points short.
[B]Round Two Happening Now[/B]
In recent days, a second wave of risk aversion has taken hold of the markets; and traders are now concerning themselves with whether this is another ‘correction’ or if we are seeing the true trend. To be sure, the fundamentals behind this move and the one in August are certainly different. The first correction was driven by a sudden demand for liquidity. Hedge funds and more venerated institutions were starting to see the value in their mortgage-backed securities vanish before their eyes; and many started to unload the tainted assets hand over fist. This time around, the call for liquidity has been far more orderly – perhaps a sign of a natural turn rather than a sentiment-driven frenzy. What’s more, the losses have become far more engrained in the business sector. The major banks wrote down a cumulative $44 billion in debt-related losses from third quarter earnings. And, if the trend in warnings continues, the fourth quarter could be even worse. This development stands in stark contrast to the few hedge funds that were going under during the August correction. Losses on the corporate level are far more tangible and effective at eroding confidence in earnings and overall economic performance. The losses for banks could in turn limit lending: further weighing down the housing market, curbing capital investment, sapping consumer spending and generally cooling the global economy. Another clue that a genuine change of trend is under way is found in risk itself. Looking back to the spread between the T-Bill and three month LIBOR rates, the steady declines have been far more stable. The picture is the same for other gauges of risk. The popular VIX Index measuring volatility in equities has marked a composed ascent this time around.
[B]What Could Make the Latest Carry Turn Less Painful?[/B]
On the other hand, record highs often generate extremes in market sentiment with the ever-pessimistic bears coming out of the woodworks calling for an inevitable turn, while bulls that have ridden the trend to its apex the first time around vehemently support a return to highs. However, there are rational arguments for a reinstitution of risk appetite. First of all, the market is still awash in cash. High inflation, surging earnings for consumers and strong profits for both businesses and investors the world over has generated a need to allocate considerable levels of capital. When investing this money, the tried and true long stocks, long carry and long commodities trades are tapped. In the currency market alone, the passive carry trade has its own drawl. The interest rate differentials between some of the most popular currencies in the strategy have grown ever more secure. For example, the Reserve Bank of Australia recently lifted its overnight lending rate to an 11-year high 6.75 percent and issued a statement and quarterly inflation report that suggested further hikes may be in the works. On the other side of the coin, the Bank of Japan which has held its benchmark cash rate at 0.50 percent since February has given no serious clues towards a follow up hike. With an unfettered, 6.25 percent annual return (that can be easily leveraged), the demand for carry will remain. Finally, from a fundamental stand point, global growth and investment remain secure – even if threats loom. GDP in the US accelerated to a 3.9 percent annualized rate, growth trends in the UK are at three year highs while those in Australia are the highest since the first half of 2004. Until these trends turn, the prevailing moves could find strong momentum.
[B]The Right Trade to Make[/B]
With the markets now in the midst of the second major risk correction of the year, the opportunity to take a long-term position is now. And, while there are convincing arguments for a placid return to risk appetite, the case for a genuine and extended risk aversion move seems to have far greater momentum behind it. From a fundamental perspective, the conditions for passive, risk-prone investment are slowly diminishing. The IMF just this past October cut its forecast for global growth. The chief economist for the Fund expressed concern that financial sector turmoil could further dampen expansion. Major US and European banks have reported losses in the billions due to the subprime-borne illness; and many analysts and economists believe we have yet to see the full impact. Taken from a different angle, market sentiment seems to already have one foot out the door waiting for the big turn. Despite the rebound from the first market-wide correction in August, risk premiums as measured in the VIX and LIBOR/T-Bill spread have remained consistently elevated. What’s more, the risk/reward behind a broad turn to risk aversion is simply far better than a return to appetite. Nearly all the assets closely associated to risk tolerance are just off of record or multi-decade highs. Further appreciation will be hard fought and limited, compared to the enticing ground to be covered in major retracements. So where are the opportunities? While equities and commodities has considerable room to move, the Forex market can mimic both of these asset classes moves and more. To take advantage of a major correction in global equities, keep an eye on EURJPY which has held a 93 percent correlation with the WSCI World Index. For a drop in oil or gold, a short in the Canadian or Australia dollars may present the best prospect. And, even the US dollar, which has been battered to record lows, could regain its safe-haven status as investors look for both a cheap and trustworthy asset.
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Written By: John Kicklighter, Currency Analyst for DailyFX.com