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The steady and relatively unimpeded rise in risk appetite over these past few months may have finally been put off its pace. After a bout of high volatility that coincided with heavy event risk, the markets seem to have lost their clear bias with momentum receding and the fundamental outlook for global growth and financial markets growing more complicated.
•Dollar, Stocks And Risk Appetite Reaction To Fed's Stress Test May Not Be Straightforward
•US 1Q GDP Sets A Disappointing Precedence For Global Growth
•Yields Continue To Contract With The RBNZ Cut Lowering The Ceiling On A Key FX Rate
The steady and relatively unimpeded rise in risk appetite over these past few months may have finally been put off its pace. After a bout of high volatility that coincided with heavy event risk, the markets seem to have lost their clear bias with momentum receding and the fundamental outlook for global growth and financial markets growing more complicated. This time around, traders and investors may require a tangible source of support to bolster their exposure while the future of risk and reward are still unbalanced. Taking measure of the market's health though, there are a few irrefutable improvements in general conditions. The key improvement comes through the DailyFX Volatility Index. Though this indicator ticked higher week-over-week; at 13.7 percent, the forecasted range of price action over the next three months is nonetheless just off its lowest levels since the September (just before the panic that led to the panic sell off in equities and a deleveraging for so many other asset classes). This is a trend that cannot be ignored as its consistency reflects an underlying improvement in a critical component of the risk/reward equilibrium. For the potential yield or return side of that same equation, the forecast is not as bright - yet. Benchmark interest rates among some of the highest yielding currencies continue to fall and will do so until there is a genuine economic recovery underway. In the meantime, the global rates will trend closer and closer to zero and subsequently close the gap (or carry) along the way. However, we have seen in this market, things can change on a dime.
How risk appetite (or aversion) develops is becoming more and more a factor of sentiment rather than a natural response to fundamentals. The effects of recession are familiar to nearly every market participant; but policy officials, economists and speculators are quickly coming to a consensus that the global economy is beginning to stabilize and is likely to recover sometime at the end of this year or into the beginning of 2010. At the same time, the slighter than expected improvement in the pace of the United States' recession through the first quarter certainly pushed this outlook back somewhat. As further growth readings from the industrialized and emerging markets cross the wires, the outlook will find further adjustments. Expansion and economic activity are inherently a platform for returns. As such, the timing of the eventual recovery will play a significant role in how quickly the rebound for speculation will be. Should the correction happen immediately, there will still be substantial yield differentials to work with and spur investment. However, with each month that passes, income producers like the Australian and New Zealand dollar will see their rates steadily depreciate. And, while there demand for return is on the rise, we cannot completely write off risk. After months of stability in the capital and credit markets, we are coming on the next major threat to calm: the Fed Stress Test. Initial reports suggest six of the 19 banks under review will come up short and be forced to raise capital. How will the market react to this? Is another collapse inevitable? Time will tell.
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.