carry trade basket

Has the Strong US GDP Reading Banished Doubts and Revived Risk Appetite and Carry Flows?

The market has finally been forced into its long overdue correction. However, is this a modest pullback or the early development of a larger trend reversal? It is still early too early to tell from both a fundamental and technical perspective; but elemental forces may be shifting in the background. Through the first half of this week, it seemed the confidence has finally collapsed under its own weight as risk-attuned securities from equities and bonds to the dollar and credit default swaps put in for sharp reversals.

•    The Delicate Balance of Maintaining Speculative Interests Running Well Beyond Fundamentals
•    What Makes the Optimal Funding and Carry Currency?

The market has finally been forced into its long overdue correction. However, is this a modest pullback or the early development of a larger trend reversal? It is still early too early to tell from both a fundamental and technical perspective; but elemental forces may be shifting in the background. Through the first half of this week, it seemed the confidence has finally collapsed under its own weight as risk-attuned securities from equities and bonds to the dollar and credit default swaps put in for sharp reversals. In fact, the broad pullback in sentiment was most aggressive that we have seen in nearly four months; and the fear that developed along with the profit taking could have gathered momentum had it not been for a well-placed US 3Q GDP release. Ultimately a strong reading from this heavy-hitting economic release has put in a temporary floor underneath the shaky markets; but is this a reversal that can develop the necessary follow through to push the various speculative markets to new to new highs for the year? Time and momentum along with another dense round of fundamental indicators and policy decisions next week will answer this question. In the meantime, we can tell from the market’s current standings that there is enough interest to feed a deeper unwinding should Thursday’s sharp rebound loose momentum. Among the more frequented asset classes, the Dow tumbled over 3.5 percent from its 14-month highs set just last week and gold fell as much as 4 percent from its record highs. For currency traders, the safe-haven dollar rallied for five consecutive sessions to a two week (on a trade-weighted basis) and the carry index suffered its sharpest plunge this week since the beginning of July.

This week’s price action is an interesting story. It would seem that a potential reversal in market sentiment was rebuffed by a key economic indicator that would single-handedly revive risk appetite. However, the response to the US growth report perhaps masks an underlying shift in sentiment with short-term volatility. Through the first half of the week when high-yield and otherwise risky assets were depreciating, there was no primary catalyst. It was simply a natural deflation in the outlook for yield. The GDP number certainly contributes to confidence as the world’s largest economy (and thereby the proxy for the global economy) reported a solid return to positive growth; but it does not really change the fact that speculative markets are living well beyond their fundamental means. For the indicator’s part, the recovery was largely in line with expectations. What’s more, much of the strength can be attributed to government stimulus and programs. The medium-term outlook still maintains a tepid pace of growth. Expansion is ultimately a means to a more important end for investors: namely more capital floating around the market and greater levels or return. Yet, the slow recovery expected through 2010 will not fulfill these aims by brute force alone. Policy officials will have to play a part in bolstering rates if the eight-month bull trend is to continue. Next week, we have the FOMC, ECB, BoE and RBA rate decisions. The RBA is the only group actually hiking; and the rest are being closely monitored for subtle signs that they are reining in their extraordinary policy efforts and taking steps towards their respective exit strategies. Regardless of what comes of this upcoming round of event risk; the further speculation diverges from risk appetite, the more inevitable a significant correction becomes.

 

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.

 

DailyFX provides forex news on the economic reports and political events that influence the currency market.
Learn currency trading with a free practice account and charts from FXCM.

Resources

• free demo account
• forex courses
• open an account
• forex stream
• free webinars