This is article is released weekdays under the heading Daily Fundamentals at 5pm EST on www.dailyfx.com
Risk appetite is still on shaky ground following the release of the Fed's Stress Test just a few weeks ago. Since then, another attempt to spark investor optimism was made; but fundamentals are stacking up against a true changing of the guard for the market.
•Risk Appetite and Carry Interest Stalled by Long-Term Concerns
•When Is It Prudent To Unwind Government Aid?
•UK Sovereign Debt Rating Under Watch - What's At Stake?
Risk appetite is still on shaky ground following the release of the Fed's Stress Test just a few weeks ago. Since then, another attempt to spark investor optimism was made; but fundamentals are stacking up against a true changing of the guard for the market. Before credit is restored and capital is once again freely invested in risk-laden capital markets, participants will need to reconcile a lack of returns against an ongoing recession, the eventual removal of government aid and the inevitable sale of toxic debt that has been held in escrow with central banks. However, these are long-term and ill-defined themes for the investment community; so how much immediate influence will they have on the capital markets? This past week, we have seen equities fail to hold on to their highest levels this year. The Dow Jones Industrial Average recently been restrained by a channel of congestion between 8,600 and 8,250 whilst volatility (as measured by the VIX) has seen a sharp advance from a recent stumble to eight month lows. The picture is much the same in the currency market. The DailyFX Carry Index has failed to mark a higher high this week; but the general bias towards positive rate differentials is clearly still on pace. As for condition indicators, volatility seemed to have marked a temporary bottom around 13.5 percent - around the same levels the market was at just before the credit crisis grew severe back in late September. On the other hand, interest rate expectations are still inching higher and risk reversals on interest-heavy pairs mark a demand for return.
Panic has been exercised from the market's memory; but the catalysts that aroused such a violent reaction from investors in the first place lingers in the background. How the market progresses from here depends on whether market participants are willing to ruminate on the potential catalysts for another financial crunch (thereby casting the general outlook in pessimism and setting the market on edge) or otherwise place their confidence in policy authorities and keep their capital in the pursuit of market-beating returns. The world's governments and central banks have been integral to developing the stability that we see today. However, the powers that be are already starting to remind the market that this support will eventually be removed from the market. At this point it is still a gamble to forecast whether we are currently in a sustainable recovery or one manufactured by the government guarantees and lending. Another eventuality is the transfer of toxic debt used as collateral for aid will cycle back out into the market. Either a bullish market will boost these products' attractiveness or they will clog the lines of liquidity again. With expirations still far off, they will not simply disappear. In the meantime, event the risk-free title assigned to government securities is coming under fiscal strains. The UK is at risk of losing its top rating and speculation is now focusing on the US. Without utter confidence from the market, these threats could leverage fear.
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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
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