This is article is released weekdays under the heading Daily Fundamentals at 5pm EST on www.dailyfx.com
It has been over six months since the financial markets last suffered a seizure that was born of panic selling or a collapse in liquidity; but does this mean the waters are once again safe for risk taking? Considering the timid recovery in equity markets and high yielding currencies through the past few months, it would seem so.
•Traders Are Taking Greater Risk Despite Deteriorating Fundamentals
•The Financial Sector Makes Progress, But Crisis Not Over Yet
•Is The Market Finding Unwarranted Strength In The G20's Promises?
It has been over six months since the financial markets last suffered a seizure that was born of panic selling or a collapse in liquidity; but does this mean the waters are once again safe for risk taking? Considering the timid recovery in equity markets and high yielding currencies through the past few months, it would seem so. Indeed, in the absence of immediate risk, foregone returns become too much for traders to bear. Looking at the broader gauges for investor sentiment, dormant threats haven't held back the clear desire to reinvest in the speculative market. A recover in equities has been paced by the benchmark Dow's 25 percent advance from its early March lows. The index is now pushing two month highs. Elsewhere, junk bond spreads are the lowest they have been since November, the CRB Commodity Index is attempting to break three months highs and credit default risk - the crux of market fears through the crisis - has making a steady recover to levels not seen this anytime this year. For the currency market, the carry strategy seems to have finally found a balance between risk reward that has allowed for speculative headway. Though yield differentials are pushing near-historical lows (and are expected to tighten even further), the extended period of calm has ellicted strength from the more prominent carry pairs - perhaps spurred by the hope of early entry on capital gains through the exchange rate. Despite all this however, caution will remain an indelible element of broader market sentiment for as long as economic recessions bear down on growth and the circulation of capital through the markets is curbed by the potential for another seismic event.
Gauging the balance of risk and reward that would draw investors back into the market is difficult; but given enough time, stable markets will stoke any traders appetite for return. This is the best way to sum up the steady recovery we have been seeing in so many different risk-loving assets. It isn't that the potential for returns has been amplified or fundamental risk has largely disappeared; but rather, relative calm has opened the door to diversification away from Treasuries, money markets and other relatively low-risk instruments (that are themselves over-extended). On the other hand, considering the health of the credit markets and the outlook for global activity; it is clear that the natural course for investment is for a steady decline in a natural bear market. Recession is still a common label throughout the global market space; and forecasts are predicting conditions to worsen before they begin to improve. The more realistic forecast for traders would not be for a recovery to develop in the next few months or quarters; but rather the absence of economic accelerants that can lead to ‘feedback effects' or tip a recession into a prolonged depression. These are the threats that theG20 objectives are attempting to head off - though confidence derived from their statement will quickly evaporate without clear evidence that major economies are treating the recession as a global one.
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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.
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 firstname.lastname@example.org.