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The collection of European monetary policy decisions, US non-farm payrolls and the results of the Federal Reserve's bank Stress Test last week seems to have been a turning point for sentiment in the market. However, the tempered pace of job losses in the world's largest economy and in-line capital shortfalls from 10 of the largest banks was more effective at curbing the ongoing recovery in optimism than supporting it.

•Can Stocks And High-Yielding Currencies Maintain Their Rally Without Fundamental Support?
•Doubts Over the Reliability of the Fed's Stress Test Growing
•How Far Ahead Will Speculators Look in Forecasting a Global Recovery?

The collection of European monetary policy decisions, US non-farm payrolls and the results of the Federal Reserve's bank Stress Test last week seems to have been a turning point for sentiment in the market. However, the tempered pace of job losses in the world's largest economy and in-line capital shortfalls from 10 of the largest banks was more effective at curbing the ongoing recovery in optimism than supporting it. Looking at those asset classes with an indelible link to sentiment and risk, it was clear that investors from all levels of the market realize that capital gains and yield can only be supported by a genuine economic recovery - which is still months away at the earliest. The deflation in optimism for stocks has been modest so far, as the benchmark Dow has pulled back less than four percent from the four month highs set just last week. The same can be said for sentiment in the currency market. This past week, the Carry Trade Index managed to top six-month highs before being turned off its steady advance. So, while the market has taken a step back, we have to consider that the bias over the past two months is still bullish on risk. However, should the shift in underlying market conditions continue alongside the fledgling trend in asset prices, we may see a true collapse in bull convictions and the revival of a long-term bear market. We are still a long ways off from this scenario though. The DailyFX Volatility Gauge has ticked above 14 percent just after exploring a seven-month low. Along similar lines, risk reversals and interest rate expectations from the most risk prone pairs have edge off their steady trends of improvement to raise the potential for a pause rather than a full-blown retracement.

From a fundamental perspective, it is ironic that risk appetite was rising into thedense round of event risk last week; and after the data crossed the wires with a positive bias, the advance would fall apart. Putting this incident into perspective though, this reaction played out exactly as would have been expected. Over the past two months, we have seen investors lower their guard against the threat of an unexpected market shock and begin to reinvest their capital into risky assets. However, throughout this period of burgeoning optimism, the outlook for economic activity and returns were in fact deteriorating. Growth forecasts from policy officials and central bankers are laden in caution even though they conservatively project a ‘slow' or ‘gradual' recovery through the end of this year and into the beginning of 2010. Meanwhile, hard data is still painting the picture of a severe recession. Advanced readings on first quarter GDP figures are looking at significant, negative revisions while timely indicators like employment maintain their painful trajectory. Now that sentiment has broken trend, investors will be more wary with their confidence. A potential concern going forward is the accuracy of the Fed's Stress Test. There is speculation that losses were understated and forecasts overstated - a questionable combo.

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Risk Indicators:

Definitions:


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What is the DailyFX Volatility Index:

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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What are Risk Reversals:

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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How are Rate Expectations calculated:

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 jkicklighter@dailyfx.com.