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

Investors and traders have waded through the most densely-packed week for event risk in months; and the initial report is that optimism has held up well despite a relatively dour mix. However, until fundamentals catch up to (and support) sentiment, the recovery will be built on unstable ground.

•Immediate Risk Appetite, Dollar, Stock Response To Fed Stress Test A Sign Of Optimism?
•Bank of England And European Central Bank Struggling To Keep Pace
•What Happens When Speculation Turns To Fundamentals For Support?

Investors and traders have waded through the most densely-packed week for event risk in months; and the initial report is that optimism has held up well despite a relatively dour mix. However, until fundamentals catch up to (and support) sentiment, the recovery will be built on unstable ground. The recent tempered pace of what is now a two-month recovery in risk appetite may be a sign that investors are slowly coming to this realization - though recent ‘better than expected' data and performance gauges have kept the various asset classes from faltering under the weight of a weak backdrop. With headlines covering smaller than expected quarterly losses for major companies and signs of a slower contraction in the global economy, side-lined market participants have been encouraged to put their capital back to work in traditional securities. The benchmark Dow has pushed to near-four month highs in a 30 percent advance from its 12 year lows. The same sentiment is reflected in the currency market. A quick recovery in carry interest has brought the Index up to its highest level since the short-term rebound following the market crash back in October. As far as support goes, a measured recovery in investment levels and yield appetite is warranted through a steady reduction in risk and very early signs of a recovery in rates of return. Volatility in the deeply liquid currency market has pulled back to levels not seen since September and the interest rate outlook for the Australian dollar has just recently ticked higher. On the other hand, market sentiment is still recovering from a near panic state and returns on every other asset are contacting. So, is sentiment overshooting the actual recovery?

Whether the current recovery in optimism and investment levels continues into the medium term will become more and more a factor of fundamentals. A natural boost in the markets is natural as participants reinvest and early speculators trying to jump back in the market to make up for their crushing losses through 2008. However, such sentiment can prevail for only so long before investors are discouraged by the lack of a return over benchmarks and risk-free instruments - or are driven away by another unforeseen shock to the financial system. For this week, another leg of the recovery has been won through the relief provided by the results of the Federal Reserve's Stress Test. Despite the government's requirement for 10 of the United States' largest banks to raise another $74.6 billion dollars and forecasts that 19 of its institutions could see a combined $600 billion in additional losses through 2010; investors were calmed by the fact that things weren't worse. However, this data shows a fundamental issue. Further losses are inevitable. More importantly, global growth is fully expected to contract going forward. At the most fundamental level of finance, returns are borne from economic expansion and the lending and investing it generates. With both the BoE and ECB reporting their efforts to shore up the markets this past week and government funds still holding things together, it is clear that a recovery can't yet support itself.


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.