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While some of the more prominent market benchmarks have yet to produce critical breaks, risk appetite is nonetheless climbing to new yearly highs. The trend has been in place since the February reversal; but this latest phase of the record-breaking recovery in optimism has been supplied by the first inklings of a global, hawkish policy stance. But, while the Reserve Bank of Australia has moved to tighten its policy reins; is the rest of the industrialized world anywhere near this step?

• Risk Appetite Growing Exuberant with Stocks on the Verge of New Highs and the Dollar a New Low
• How Directly does the RBA's Policy Stance Mimic its Global Peers?
• Keeping a Tab on Growth and Financial Stability

While some of the more prominent market benchmarks have yet to produce critical breaks, risk appetite is nonetheless climbing to new yearly highs. The trend has been in place since the February reversal; but this latest phase of the record-breaking recovery in optimism has been supplied by the first inklings of a global, hawkish policy stance. But, while the Reserve Bank of Australia has moved to tighten its policy reins; is the rest of the industrialized world anywhere near this step? This is a crucial fundamental question that each investor should ask themselves before buying into increasingly expensive markets; yet it one that seems to be consistently eclipsed by expectations of steady capital gains that more than compensate for the lack of yield, dividends and other steady sources of investment income. To project where this market is ultimately destined three, six and 12 months ahead; we need to ask whether the capital that is flooding back into speculative markets is in for the long haul or not. However, before we get around to answering that question, we need to take account of the current health of key markets. Looking to the benchmarks of the speculative world, we can see that markets are trying to catch up to optimism. For FX, the carry trade basket has pushed to a fresh, one-year high to extend the now eight-month trend channel. Breaking this aggregate measure down, we see the US dollar is on the verge of collapsing to a new 14-month low on a trade-weighted basis. From funding to carry currency, the Australian dollar has at the same 14-month high against the US dollar and a 15-month high when measured up against the euro. For comparison, the Dow Jones Industrial Average is stationed just below this year's highs and crude is just arms reach from overtaking $75 to dive into waters not tested since the financial meltdown.

Back to our fundamental quandary. The market's (and therefore optimism) has generally pushing yearly highs; but returns to support this interest have so far been muted. Speculation naturally precedes the actual rise in yields; but the dramatic reversal that capital markets have generated in the span of a year seems to suggest the bullish conditions of today rival that of three years ago (the the basis of tempo). It is no stretch to say there is potential in the recovery taking place; but it is certainly well beyond reason to suggest that the market can keep its current pace up for much longer. The most prolific influence for bullish convictions at this point is the steady stream of funds finding their way from safe haven to asset classes with positive real returns. Naturally there is a glut of capital that is still finding harbor in money markets and government bonds. Yet, those investors still on the sidelines are clearly still concerned about the prospects for return and risk. There is a level of skepticism in the current run up that has many waiting for a significant correction before the next wave of funds filter through. It may be difficult to gauge; but it isn't hard to conceptualize the argument that many investors jumped in to take advantage of the capital gains found in buying low and selling high. Now, the problem is that we are buying hand and trying sell higher. The stable income from yields and dividends - the foundation for long-term investors - has not established itself. Certainly, the RBA has set a precedence with its rate hike this week; but few others are ready to follow suit.

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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 USDJPY as global interest are bottoming after having fallen substantially over the past year or more. Both the US and Japanese benchmark lending rates are near zero and expected to remain there until at least the middle of 2010. This attributes level of stability to this pairs options that better allows it to follow investment trends. When Risk Reversals move to a negative extreme, 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? You can send them to John at jkicklighter@dailyfx.com
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