Despite Short-Lived Setbacks, Risk Sentiment and the Carry Trade are Still Set in their Long-Term Bull Trend

•    How will the Market React as the Governments Accelerate their Withdrawal of Stimulus?
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We have a conflict in signals between long- and short-term assessments on the markets, fundamental and technicals analysis and even the risk bearings on asset classes. There is no doubt when taking a quick glance at the benchmarks for the various asset classes that the dominant bull-trend is still in place. However, a more thorough evaluation of sentiment read in the markets over the past few weeks reveals a burgeoning sense of doubt and perhaps the early steps toward a wave of profit taking. There are many signs that we can point to for confirmation that the balance of risk appetite and aversion are starting to tip in the opposite direction. The most accessible evidence we have is the hesitation in those key risk barometers. Perhaps no instrument is as pure a measure a gauge for sentiment as the US dollar. The world’s most liquid currency was prized for its safe haven status through the worst of the financial crisis. Now, backed by one of the lowest benchmark lending rates (Libor) and weighed by record-breaking deficits, the famous currency has turned infamous as investors ‘short’ it droves to fund their carry trades. The association has grown so prominent, that even the IMF has labeled the greenback the currency market’s funding currency. And, considering the clear connection, we have to consider Dollar Index’s rebuff of forging new 15-month lows this past week and back in October as a meaningful sign of hesitancy. A somewhat different view can be garnered from crude. The commodity is a healthy mix of tangible fundamental forecasts and indefinable speculative interests; and the three-weeks of congestion suggests something is amiss. How quickly could sentiment actually change? Just last week, the Daily Volatility index surged to a four-month high and immediately retraced. Conditions are tense.

Shifting gears from a technical to fundamental appraisal of the prevailing market winds, there has long been a divergence between the pace of the markets and the expectations for growth and interest rates that support it. Speculation is a force of its own though and ‘irrational’ investor behavior can persist as long as the inflow of idled funds from the sidelines can support investors’ expectations for making capital gains by buying high and selling higher. However, there is a distinct difference between those funds that are used for trading and those for investing. The former is put into pursuit of those market swings that have been so profitable during the market’s aggressive advance. The latter is directed by a far more cautious crowd that can only be lured back by the proper balance of stability and reasonable yields. If the eight-month bull wave that has defined the year truly stalls and starts to meet a real correction, we will see just what the makeup of the broader market is. Speculators will worry only about booking profit and avoiding losses; while investors would be more willing to hold through the correction, collecting yield income in the meantime. The gears may already be turning for establishing such an event. Most of the world’s governments and central banks are beginning to remove stimulus from the system. The absence of this safety net will expose the market to its own stability – a dangerous proposition. In the absence of such a backstop, anemic yields will be compared to ballooning unemployment, rising bank defaults, bloated fiscal deficits and burgeoning asset bubbles. This is not a disparity that can last for much longer. For now, investors have simply grown more selective by putting their capital into emerging markets to ride growth; but in a true correction, this area will experience the sharpest correction.

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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.