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

The markets have seen a dramatic reversal in sentiment this past week. And, the source for this optimism? Earnings. Before Goldman Sachs reported record earnings earlier this week, however, the markets and risk appetite were folding under the weight of objective fundamentals that looked to pull speculation back to current conditions. Now traders have to ask whether this catalyst from earnings is the trigger for a larger trend or merely a temporary retreat from the reality of the market and global economy's health.

•Risk Appetite Tempered as Credit Threats Meet Strong Earnings
•Where Does Long-Term Economic and Yield Growth Fit In?
•Policy Officials Trying to Keep the Doors Open to Fiscal Stimulus

The markets have seen a dramatic reversal in sentiment this past week. And, the source for this optimism? Earnings. Before Goldman Sachs reported record earnings earlier this week, however, the markets and risk appetite were folding under the weight of objective fundamentals that looked to pull speculation back to current conditions. Now traders have to ask whether this catalyst from earnings is the trigger for a larger trend or merely a temporary retreat from the reality of the market and global economy's health. With second quarter GDP numbers starting to cross the wires and financial troubles still looming, the market may not hold an easy correlation to earnings for very long. Taking stock of sentiment through the current position of markets, the recent revival in risk appetite has nearly recharged the bullish trend that has been shaped since March. With its clear connection to investment flows, equities have been a beacon for this week's rebound. A string of four, consecutive bullish sessions has driven the benchmark Dow Jones Industrial Index more than 7 percent higher and within arm's reach of surpassing the six month highs set in June. For the Forex market, the change in sentiment has catalyzed volatility in the yen crosses and other risk-sensitive pairs. The Carry Trade Index has rallied 2.5 percent since last week; but the real shift can be seen through price action as the pull back that opened this month is almost fully retraced. However, at this point, we need to consider what will happen when volatility fades. If sentiment cannot build on itself, we may not see critical breaks; and from there, tempered expectations for yield and burgeoning hazards in the background can accelerate another pullback.

A look at a chart of a equity or carry trade index shows a broken trend that is trying to reestablish itself. This is a good reflection of the fundamentals that underly this price action. Up until this week, economic readings and forecasts seemed to be leveling off. FOMC and IMF growth projections were offering modest upside revisions; but were still steeped in disclaimers. At the same time, the consistency in slow improvements behind economic data began to ebb. In turn, speculation that a recovery was at hand began to waver. Then, optimism was revived by a series of surprisingly strong earnings reports. With Goldman Sachs revealing record profits and blue chips like Intel beating forecasts, investors were ready to believe returns could be made even if it does take the economy time to find its way back to positive growth. However, the bar has been set high for future earnings releases; and in the meantime, there are other concerns for market participants to account for. Perhaps the most immediate threat to financial stability is CIT. On the verge of bankruptcy, the US government denied the company any further financial aid, deeming its potential failure not a systemic risk. In the end though, credit markets will be the judge of that. Also, while sentiment is jostled back and forth, second quarter growth readings will offer an unbiased state of affairs. China has already impressed, but the UK's recession is expected to balloon in next week's report.

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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? You can send them to John at jkicklighter@dailyfx.com.