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The market finally saw its steady rise in optimism knocked off track this past week. After such a heady buildup in sentiment, it took the collective influence of dreary growth projections, growing financial troubles and the G8's refusal to cater to investors' sentiment-fueled rally to win a temporary break in risk appetite.

•Risk Appetite Weighed by Forecasts for Recession, Looming Financial Risks
•Financial Leaders Defer the Government's Withdrawal From the Market at G8 Meeting
•US Banks Suffer Downgrades, European Officials Refuse Stress Test

The market finally saw its steady rise in optimism knocked off track this past week. After such a heady buildup in sentiment, it took the collective influence of dreary growth projections, growing financial troubles and the G8's refusal to cater to investors' sentiment-fueled rally to win a temporary break in risk appetite. However, the general bias has not changed. Risk appetite retains the positive bias that has encouraged speculative funds back into the market for nearly four months now. The current period of indecision instead offers an opportunity for fundamentals to truly catch up to price action. Looking across the more popular measures of risk appetite, we have seen the Dow Jones Industrial Average drop below the floor of the 8,600-8,850 range that had equities sidetracked for nearly two weeks. More attuned to the growth forecasts derived from positive sentiment, commodities put in for their biggest correction since late April. Even the more sensitive credit market gauges deteriorated despite the government's steadfast liquidity and guarantees. Credit default swap premiums have risen more than 17 percent in the past week. How has this shift in attitude presented itself in currencies? The Carry Trade Index has violated its stable rising trend and marked a double top with the peak set at the beginning of this month. With risk reversals and yield forecasts turning lower, the scales of risk and reward seem to be once again shifting.

While they have taken a back seat to sentiment in the past few months, fundamentals have always been there for market participants scrutiny. And, a critical look at the growth forecasts and burgeoning financial troubles at eye level certainly do not support a rabid redistribution of capital into risk assets. This past week, the headline event was the two day G8 summit in Lecce, Italy. Rhetoric from the Finance Ministers was generally mixed; but the official statement maintained a cautious tone. Growth was deemed the top priority; and considerations for the government's exit strategy was deferred to a later date. Record budget deficits no doubt present a significant long-term problem for individual economies; but they also support an economic recovery in the near-term. This is an important point considering the IMF forecasts the global economy to see its first contraction (1.3 percent) since the Great Depression and there are numerous financial concerns that could quickly escalate into crises. An ongoing risk to the world's financial markets is the health of US banks. Just this past week, Standard & Poor's downgraded 22 American banks - seven of which were TARP recipients. And, despite the lingering risks with liquidity and future earnings, nine of the 19 banks that were put through the stress test paid back a total of $68 billion of their government loans. The trouble isn't isolated to the US though. European officials refuse to perform a stress test on their own banks even though the ECB has forecasted another $283 billion writedowns this year (the IMF projects $904 billion).

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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.

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.