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

The markets seem to have already settled the future of risk appetite; but the fundamentals behind the steadfast, bullish bias are far more dubious than speculators seem willing to believe. Over the coming week, a dense round of fundamental data will set the course for the supposed economic recovery; but the first blush interpretations and immediate market response may not offer the full picture.

•Markets Batten Down for a Heavy Week of Event Risk Starting With US GDP and Ending with NFPs
•Interest Rate Forecasts Bolstering Premiums that Commentary and Fundamentals don't Support
•What Kind of Recovery Should We Expected 3 Months, 6 Months, a Year from Now?

The markets seem to have already settled the future of risk appetite; but the fundamentals behind the steadfast, bullish bias are far more dubious than speculators seem willing to believe. Over the coming week, a dense round of fundamental data will set the course for the supposed economic recovery; but the first blush interpretations and immediate market response may not offer the full picture. Speculators are concerned with both the risk and potential reward aspect of each trade. And, without a solid foundation for an economic recovery, yields will not be able to compensate for a growing sense of uncertainty. In the meantime, most of the measures for investor sentiment have dispelled any sense of concern by forging new highs. The benchmark for capital flows, the Dow Index has maintained its position above the closely monitored 9,000 milestone and has recently gone so far as to test new highs for the year. In the far more liquid currency market, speculative bearings have developed through the realigned carry trade. It has not taken long to fully recover the drawdowns the Carry Index suffered through the first two weeks of July and then go on to forge nine-month highs. Supplementary measures have furthered the bullish case as volatility for the broader FX markets maintains the bearish trajectory followed over the entire year. Yield forecasts have similarly followed a the optimistic line to make a case for premium that fully compensates for supposedly diminishing levels of risk. It is only through options, where protection is drawn, that a fault can be found in this scene.

Speculation is an indispensable element of the markets. However, significant changes in fear and greed can distort the fundamental outlook and set the stage for corrections that bring prices back in line with rational values. In the bull market that has essentially spanned the whole of this year, the recovery is founded primarily on the return of capital into the speculative arena. After months of stabilization, managers and individual investors are ready to make returns that can outpace the risk-free assets that were relied on for liquidity. So far however, the carry trade has offered little in the way of return; and in fact, yields are still contracting. This means that interest is built upon expectations for rates of return to perk in the near-term - and expand consistently thereon. There has been much coverage to the ‘early signs' of an economic recovery in monthly data. However, the evidence of such a ‘V'-shaped recovery is uneven and unconvincing. An economic recovery based on government spending, corporate cost cutting and improved trade flows through a lack of demand on both sides will not last. Globally, unemployment and wages are still rising, consumer spending has all but vanished, capital investment is falling and the debt burden is still at unsustainable levels. Given enough time, all the factors may come into alignment; but that is a commodity the markets cannot afford. Sentiment may be swayed to match fundamentals (or vice versa) over the coming week. Friday will offer an objective read on the economic health of the world's largest economy; and a significant improvement in its pace of recession is expected - though not a confirmation of growth. From there, rate decisions and NFPs will carry the docket.

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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.

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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? Send them to John at jkicklighter@dailyfx.com.