This is article is released weekdays under the heading Daily Fundamentals at 5pm EST on www.dailyfx.com

Market sentiment has stabilized over the past week as traders wait for fundamentals to either catch up to optimism or draw the budding recovery to a grinding halt. Ongoing earnings releases, first quarter growth reports from the world's largest economies and a series of meetings attended by global policy makers can decide the fate of growth and optimism for months to come.

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Market sentiment has stabilized over the past week as traders wait for fundamentals to either catch up to optimism or draw the budding recovery to a grinding halt. Ongoing earnings releases, first quarter growth reports from the world's largest economies and a series of meetings attended by global policy makers can decide the fate of growth and optimism for months to come. Heading into this pervasive fundamental wave, traders from all asset classes have taken to caution. Reflecting the more speculative side of the market, the benchmark Dow Jones Industrial Average has curbed its most aggressive rally in two years. On the other side of the coin, interest in Treasuries has recovered while risk premiums through credit default swaps and other financially sensitive securities have curtailed their slow improvement. Unsurpassed liquidity makes the currency market the most discerning gauge of risk appetite versus risk aversion though. The Carry Index has extended the timid decline that began at the beginning of this month. However, looking beneath the surface of this complex measure, panic is further subsiding while expectations for returns slacken. Volatility for the broader currency is the lowest it has been since before the October market crash and credit seizure (despite the presence of event risk). In contrast, the scales of risk/reward have been balanced by shrinking yield forecasts (the interest rate outlook) and souring expectations for capital returns (risk reversals).

A sort of equilibrium has been struck between the potential for limited rates of return and the fading sense of fear that has encouraged reinvestment into the speculative areas of the market. However, as we have said many times before, this should not be considered a genuine recovery. Rather than a reduced pace of recession, a natural return to optimism and sentiment must come from positive forecasts for economic activity rather than a diminished pace of contraction. The round of event risk scheduled over the coming weeks provides the most comprehensive measure for health that we have been presented in months. The most pressing burden on sentiment are the gatherings of policy officials in Washington DC. On Friday, the G7 and G20 will convene; but the topics for discussion are not certain. The most meaningful outcome to the gathering of finance ministers would be a list of definitive steps and responsibilities aimed at turning individual and national rescue plans into a global one. This was the aim of the last summit in London; but so far, there has been little in the way of remarkable progress towards this goal. Whereas government policies for economic and financial aid support risk and reward equally, earnings activity and scheduled GDP releases will impact one or the other. The UK and US growth reports have obvious implications; but the accounting data is a more nuanced measure of risk through delinquencies and writedowns.

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.