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It is only a matter of time before the rebound in investor sentiment is measured against the current (and expected future) state of fundamentals. With corporate earnings crossing the wires and first quarter GDP numbers soon to be released, those trading safety for the prospect of yield will soon see whether their balance of risk and reward can truly hold up.
•Risk Appetite Put Off Its Pace As Growth And Earnings Forecasts Factor In
•Fed Moves The Results Of Its Stress Tests To Next Month
•Will Earnings Reports That Are Deep In The Red Encourage Investor Confidence?
It is only a matter of time before the rebound in investor sentiment is measured against the current (and expected future) state of fundamentals. With corporate earnings crossing the wires and first quarter GDP numbers soon to be released, those trading safety for the prospect of yield will soon see whether their balance of risk and reward can truly hold up. Taking stock of optimism through the activity of the market's most speculative asset classes, we can still see momentum behind a bullish crowd. Despite the significant and ongoing event risk for the equity market, the S&P 500 has pushed ahead to a new, two-month high; while the VIX volatility index pulled back to its lowest level since September. Looking up to the banks-level of investing, we can see the same buoyancy through thawing credit and deflating risk premiums. Credit default swaps are the cheapest they have been since before the October market collapse. Even junk bond spreads have eased nearly 15 percent off their record highs just a month ago. However, there are signs that this rebound is running short on momentum and is looking for fundamental fuel to sustain a true recovery. Such evidence is most apparent in the currency market. The Carry Trade Index advance has stumbled, while both the US dollar and Japanese yen (the two primary safe haven currencies) cut off unfavorable breakouts. Looking behind price action, risk continues to ease with FX market volatility the most stable it has been since the beginning of October. Alternatively, the returns continue to deflate along with economic activity.
Though there has not been a sharp reversal in the markets, there has been an irrefutable deceleration in the broad-based rally. The resurgence in optimism since the beginning of March has, to this point, largely sustained itself on a deflation in perceived risk. Market sentiment and trends are essentially based on an equilibrium of risk versus reward. It stood to reason that after months of congestion and in the absence of another financial crisis, side-lined capital would eventually find its way back into risk-sensitive assets. However, the scales have yet to permanently shift in favor of yield seeking. Looking at the other side of the equation, we still see a severe lack of return on those securities that sport the necessary liquidity to define broad financial trends. And, considering both current data and forecasts are pointing to further retrenchment in yields and returns, there is little reason to believe investors will be rewarded for their speculative investments any time soon. This may be a realization that translates into price action over the next few weeks as major corporations release their quarterly earnings reports. So far, there have been a few notable reports that have beat expectations; but it is important to recognize that they are still firmly set in the red. This concept will be particularly significant with the US Bank's quarterly numbers. With the Fed pushing back the results of its stress test until May 4th; speculation will develop through income, write downs and plans to pay back TARP loans. What's more, we will also start to see returns on a global scale as GDP numbers start to print.
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.
Questions? Comments? You can send them to John at email@example.com.