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

How much capital was sidelined during the worst of the financial crisis back in October and November? This is perhaps one of the most important yet overlooked questions in the market. The rebound in markets and sentiment that began back in early March was no doubt founded through optimism; but this confidence extends only as far as drawing risk-tolerant investors out of risk-free assets like treasuries into the regular investment space.

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How much capital was sidelined during the worst of the financial crisis back in October and November? This is perhaps one of the most important yet overlooked questions in the market. The rebound in markets and sentiment that began back in early March was no doubt founded through optimism; but this confidence extends only as far as drawing risk-tolerant investors out of risk-free assets like treasuries into the regular investment space. For the markets to truly enter the next bullish phase, the outlook for growth and returns has to compensate for the prevailing level of risk. And, considering officials' growth and earnings projections, the future does not look very bullish. Taking stock of the progress of market to this week, we can see the congestion that developed in June after three months of steady advance has started to progress into declines. This was clearly visible in the traditional markets with the S&P 500 down nearly 8 percent from its June highs after having cleared popular support at 8,200. Good will ran thin for commodities as well. Crude seemingly ran too high in its surprisingly consistent advance from February; and subsequently, the price for one of the world's most precious resources dropped 19 percent in the past seven days. For currencies, the turn has been more measured on an individual pairs' basis. However, looking at the carry trade as a barometer, we have seen a clear break of trend over these past few weeks. Options activity and yield forecasts have supported this move; but it is important to note that volatility is not deeming this a panic move.

In determining whether the risk appetite and the broader markets are going to rise over the next week, month or any time frame; you need to define those factors that are most pressing to the balance of risk and reward. After plunging to a six-year low following the credit crisis late last year (and holding at these lows through the first quarter of this year) we have seen the need to discount another financial seizure or extend the depth of the global recession ease. However, should we be on the same track as the best of the 2006/2007 rally when the world's advanced economies are still mired in recession and budget deficits are creating unprecedented complications for the future? In a word, no. We may be seeing some sense of equilibrium where the market at large believes the worst of the financial and economic troubles have past but that positive growth and attractive returns are not yet within site. The IMF updated its benchmarks on global growth. A modest downward revision to this year's forecast (from a 1.3 percent contraction predicted in April to a 1.4 percent slump this time around) was offset by the positive adjustment to the 2010 figures (from 1.9 percent to 2.5 percent expansion). At the same time, those forecasts for the world's leading economies (the US, Euro Zone and Japan) were far more reserved, suggesting an ‘L'-shaped recovery. And, these forecasts will in turn determine the market's pace. Credit is not finding its way from banks to consumers; and yet stimulus unwinding is already being discussed at the G8. The next hurdle is 2Q earnings next week.

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
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