This is article is released weekdays under the heading Daily Fundamentals at 5pm EST on www.dailyfx.com
Risk appetite in most regions of the financial market is still actively suppressed by skepticism over early growth warnings and concern surrounding the eventual unwinding of government support from a still fragile global economy.
•Carry Diverges From Risk Appetite: What are the Risks to a Market Recovery?
•Outlook for Yields Starting Rising To Levels That May Compensate for Lingering Risk
•Will G8 Finance Ministers Discuss Spark Volatility?
Risk appetite in most regions of the financial market is still actively suppressed by skepticism over early growth warnings and concern surrounding the eventual unwinding of government support from a still fragile global economy. However, shirking the caution seen most prominently in the equities market, carry interest have surged this past week. Looking at the Carry Trade Index, a sharp 430 point rally this past week has pushed the gauge to retest the 10-month high set early last week. Why the divergence? The answer lies in the market conditions numbers. The DailyFX Volatility Index has shown a quick retreat from the aggressive rise in sentiment that transpired over the previous four weeks. This is in line with the deflated fear indicators for the other traditional asset classes (the VIX, junk bond spreads, credit default swaps, etc). More interesting, however, is the improvement in the other side of the traditional risk/reward balance in the market. While market sentiment is still the primary source of strength for most investments; there have been a few key changes to yields over this past week to support the traditional carry trade basket. Most notably, the RBNZ announced it would hold its benchmark unchanged at 2.50 percent and forecasts for RBA interest turned decidedly hawkish in the span of a few days. Is this shift in returns indicative of the larger currency market? No. However, when sentiment is balanced like it has been over the past few months, a factor like this can make all the difference in the world.
Sudden shifts in yield speculation or sentiment like we have seen this past week are critical for swing traders; but for carry interests, they can be a dangerous distraction. A stability in risk and return is essential for supporting the longer-term strategy. And, considering the evolution of fundamentals this past week, there is little reason to believe that optimism is on the verge of a sudden and complete return. To be sure, there were a few positive events to take account of. The two highest yielding, liquid currencies reported a positive shift in their respective rate forecasts. What's more, the outlook for an economic recovery was furthered by a far smaller-than-expected drop in US payrolls. However, these are still dull readings in an overwhelming gloom. There is a consensus among policy officials and market participants that current recession will hold over for the rest of the year and that even the eventual recovery will be drawn out and slow. In fact, the World Bank today downgraded its forecasts for activity through 2009 from a 1.7 percent contraction in March to 3.0 percent slump. In the meantime, there are plenty of factors that could derail a recovery. Sovereign debt ratings, ballooning budget deficits, struggling financial institutions, diminishing confidence in safe-haven assets and the government's eventual withdraw of its financial aid are all big ticket issues. The mention of any one of these at this weekend's G8 meeting could substantially alter sentiment.
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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.
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.
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.
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@example.com.