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Defining the underlying trend is not as important as determining the next catalyst when assessing the health of the markets. Risk appetite has extended its steady advance for yet another week; but the confidence that supports this trend grows increasingly taxed from a fundamental perspective with each day.

• What will be the Next Catalyst for Risk Appetite behind Stocks, Currencies?
• Is the Dollar taking over the Yen's Role as Primary Funding Currency for Good?
• Looking Forward to the G20 Meeting in Pittsburgh

Defining the underlying trend is not as important as determining the next catalyst when assessing the health of the markets. Risk appetite has extended its steady advance for yet another week; but the confidence that supports this trend grows increasingly taxed from a fundamental perspective with each day. At this point, the dollar has plunged to a new yearly low and the Dow has forged to an equivalent high; but what will keep these benchmark assets on pace - and will a steady appreciation necessarily confirm the next long-haul bull trend? One of the most influential drivers behind the now, six-month recovery is momentum. One of the side effects of the steady climb from March's low is capital returns. There are two general methods for making money in the market: profit from asset appreciation (depreciation if you are short) or collect interest. With the global economy still struggling to facilitate expansion and policy makers the world over holding benchmark lending rates at recent record lows; there is little premium from traditional yields. Therefore, the development of a bull phase relies primarily on the market's ability to maintain trend. What happens then when there is a retracement (an inevitability)? Whether a natural correction, wave of profit taking or genuine reversal in sentiment; the market will turn lower eventually. When it does, market flows or fundamentals will have to step in to buffer the turn momentum. For market flows, there are still vast sums of money in safe havens like money market funds and Treasuries. If capital pours into the speculative arena fast enough to counter the bearish forces, the markets may still hold up; but would obviously cautious investors diversify in a heavy market?

Looking beyond the mechanics behind market flows, fundamentals are still the foundation for the long-term trend. Conditions are certainly improving in the sense that the worst of the financial crisis has passed and the threat of another seizure has been reduced dramatically. However, that does not mean that we will automatically transition into the next, multi-year bull phase. The loss of wealth through the near market collapse of 2007/2008 was unprecedented. Not only will investors be cautious with their remaining capital for some time; but the access to leverage and credit will be as limiting as the reduced buying power. Eventually, the markets will have to align themselves to the general pace of economic activity (the natural source of returns). In this respect, conditions are improving with the US, Euro Zone, Japan and other industrialized nations expected to expand through the second half of the year. However, policy makers from most of these economic leaders caution growth will be weak, stagnate, and gradual. Naturally, we would expect returns from capital markets to take up the same tempo. What's more, there are still potential road bumps down the line. Naming a few of the lingering issues: leverage is nearing its highest level since before the subprime meltdown; the Federal Reserve is reviewing banks' exposure to commercial real estate debt; and many emerging market economies have yet to find the bottom to their recessions. One event that comes with a time frame is the G20 meeting in Pittsburgh over September 24th and 25th. This timing means the market can react to announcements in real time - and a close eye will be kept on stimulus, financial regulation and exit strategies.

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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.