carry trade basket

Optimism Still Rising as The Fundamental / Speculative Gap Grows

Emboldened by new highs and early signs of rising yields, risk appetite has pushed to a new high for the year. However, the progress made week-over-week was very limited. Once again, investors and traders have reached the point where caution and skepticism has stalled the steady appreciation that the markets have otherwise carried on with since February. Perhaps we have come to the next tipping point in speculative interests where stable fundamentals are needed to draw in the next wave of funds to feed the capital gains of those that have already taken the plunge.

•    Will 3Q GDP Readings Help or Hinder Bulls Steady Drive Higher?
•    Bullish Yield Forecasts are no Longer Limited to Just the Vocal RBA

Emboldened by new highs and early signs of rising yields, risk appetite has pushed to a new high for the year. However, the progress made week-over-week was very limited. Once again, investors and traders have reached the point where caution and skepticism has stalled the steady appreciation that the markets have otherwise carried on with since February. Perhaps we have come to the next tipping point in speculative interests where stable fundamentals are needed to draw in the next wave of funds to feed the capital gains of those that have already taken the plunge. And if there were ever a single piece of event risk that could confirm or rebuff forecasts for a stable, bullish market and a revival of yields; it would be the quarterly growth data. Heading into this heavy round of economic data, we can see the hesitation in price action. For the currency market, the dollar may still be on its bearish path; but its pace of descent has clearly cooled. EURUSD is arguably the benchmark for the pace and direction of the top funding currency candidate; but AUDUSD is better for measuring market sentiment. Despite being spurred on by the RBA’s aggressively hawkish monetary policy stance, the pair has stalled this past week at 0.93. This is unusual considering the fundamental contrast seen between the US and Australian dollars. Even the more accessible and popular equities market is showing indecision. The benchmark Dow Jones Industrial Average has loosely been confined to a 10,100 to 9,900 range since last Wednesday. It seems, regardless of what direction sentiment eventually takes, we will soon find some resolution on direction.   

In the past weeks and months, we have seen multiple instances of congestion after a leg of bullish price action; and inevitably, optimism picks up where it left off. The is the nature of any market. A trend will eventually grow exhausted; and that offers the opportunity for continuation or a reversal. The speculative rally that the markets have been able to run for most of the year is still running well beyond the reasonable limits of the fundamental backdrop; but a few developments may have actually furthered confidence and ensured the next round of sidelined capital finds its way into the speculative arena. The outlook for yield has taken a notable turn for the better over the past week. The RBA took another broad step into hawkish territory recently when Governor Glenn Stevens said that he would tolerate further appreciation in the Aussie dollar in his efforts to rein in monetary policy. And, though this was the most unabashedly hike-oriented language to come out of the central bank circles; we have seen a subtle shift amongst many authorities. The BoE is expected to announce its intentions to take a break from its quantitative easing efforts at its next rate decision in November and the Fed is testing reverse repos in the money markets as a way to remove liquidity from the market without collapsing bank balance sheets. The next fundamental milestone is the third quarter GDP numbers. China has already confirmed an impressive pace for the period; but the United Kingdom’s reading will be the first for an industrialized country. What’s more, since the UK is considered the underperformer of the G-20, it could define the lowball estimate for global growth. Next week, the stakes are raised with the activity report for the US.

 

Risk Indicators:	Definitions:
	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 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.
	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.
 

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