Risk Appetite on the Verge of Collapse, All that is Needed is a Catalyst

•    Risk Appetite on the Verge of Collapse, All that is Needed is a Catalyst
•    Unusual Liquidity and the Dubai Credit Scare Veil a Genuine Correction in Sentiment
•    Yield Forecasts Deteriorate as Speculation meets Fundamentals

The past two weeks have been extraordinary ones for the markets and underlying sentiment. It had seemed that the thin liquidity through the US Thanksgiving holiday combined with fear born from a potential credit crisis emanating from the Middle East would trigger the first serious correction in risk appetite since the capital markets began appreciating back in February. In the end, both conditions would prove temporary; and traders regained their footing. However, this period of instability has exposed a deep-seated incongruity that has developed just under the surface of the seemingly impervious bull market for some months: that risk appetite has far outpaced reasonable expectations for returns. Ever the balance of risk and reward, the markets have backed up to the brink of a true shift in underlying sentiment; but there is still a critical final step that must be taken to validate the turning of the tides. And, this change can come through fundamentals or through market flows themselves. In the nine-month buildup in capital markets to this point; the outlook has improved modestly. In accounting for the scenario for a potential financial collapse (a genuine fear last year) to a return to a stable foundation for pricing and capital flow; there can certainly be a significant adjustment in pricing. Yet, the bullish interest that has developed since the beginning of the year goes well beyond a ‘correction.’ It is not difficult to interpret 60 percent-plus advance in equities, record highs for gold and sixteen month lows for the US dollar as being excessive. Considering a buildup in risk appetite (or positioning that has supported it) was responsible for such extremes, it stands to reason that the market itself will regulate positioning.

The scenario for a market-founded correction isn’t a complicated one. As funds have been invested back into the capital markets at near the same pace that they were withdrawn; the benchmarks have reported record-breaking advances. However, the recapitalizing of the financial system comes with a number of drawbacks. One indisputable fact is that total global wealth has been severely reduced by the 2007-2008 financial crisis and economic recession. A more elemental issue is sentiment as it relates to true fundamentals. Investors have put their capital back into a market that produces very low levels of natural return; and rates of return are not expected to significantly rise in the near future. This means much of the influx to this point has been founded on speculative returns through capital gains. Recovering from the losses of last year, money managers would likely prefer booking some of their profits for the year, rather than hold out through a correction that could ultimately kill the abnormally bullish pace that has been enjoyed to this point. Another concern that is gaining more traction in recent months is the withdrawal of government support. Trillions of dollars worth of guarantees, bail outs and toxic asset purchases have been spent to prevent a financial collapse. Now that it looks like the markets are back on an even keel, the world’s governments will look to reign in this stimulus to work down deficits and further stabilize the private sector. We can already see this take place with the ECB ending its stimulus injections, the Fed testing repos to drain cash and China looking for ways to curb lending. However, this will be an extremely delicate procedure as an exit that is too early can spark another panic; while staying too long can fix to deflation or hyper inflation. It is now a matter of ‘when’ not ‘if’ sentiment will buckle.

Is Carry Trade and risk appetite rising or falling? Discuss the market sentiment and how to trade it in the DailyFX Forum

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.