Despite the US Dollar’s Rally, Underlying Risk Appetite has yet to Break

•    Despite the US Dollar’s Rally, Underlying Risk Appetite has yet to Break
•    How Significant a Threat are Sovereign Defaults and Bank Write Downs in 2010
•    Yield Forecasts are Deteriorating Rapidly as Economic Reality Setting In

Over the past two weeks, the US dollar has surged across the board. And, considering this currency has stood as the primary funding currency to a burgeoning carry trade, it makes sense that the greenback’s performance could be interpreted as a sign that risk appetite is toppling. However, cause and effect do not connect here – at least not yet. Instead risk trends have extended the congestion that has set in since October/November; and the period of consolidation has allowed the world’s reserve currency correct speculative and fundamental extremes on its own. Yet, that should not be taken to mean that investor optimism, and the leveraged positioning it has encouraged, will not go uncontested. In capital markets’ aggressive rally throughout 2009, volatile speculative interest has overwhelmed comparatively stable investor inflows. There is a critical distinction between these two categories. Speculators (or traders) are looking for capital appreciation and will need to eventually book profit on their outright positions. In contrast, investors are looking for long-term appreciation, dividends or some other form of consistent interest income. This dichotomy helps expose the tension that has developed behind the scenes recently. Primary barometers for risk appetite like the Dow Jones Industrial Average and the Carry Trade Index - instead of correcting before the drain in liquidity that occurs at year-end - have developed tight ranges. This presents considerable tension for a market that is looking at potentially volatile conditions in the near future but not enough depth to establish a true trend.

All that is needed to tip risk trends into a tailspin is a definitive catalyst. We have plenty of potential threats to global, financial stability; but optimism or greed for greater returns has helped the markets weather most of tremors. This likely means that we need a market-based event. A particularly large withdrawal of capital from the speculative arena or the seizure of a critical node in the broader financial market could certainly spark a panic that leads to a cascade selling event. Ironically enough, the best opportunity to force the Dow below 10,250 or pitch the carry interest into a bleak bear trend is during the low liquidity-period that is approaching. While there is not enough market depth to maintain and develop a reversal; the low liquidity means it will be easier to unbalance sentiment. Therefore, we need only keep a vigilance on the already incubating fundamental troubles that have developed over the past few months and be ready for a new shock to catalyze price action itself. Among the key trends to watch, the threat of defaults on a corporate and national level is particularly troublesome. Not long ago, the IMF warned that the world’s banks have only accounted for half of the losses they will ultimately suffer from following the worst financial crisis since the Great Depression. Now, we are seeing downgrades on sovereign credit ratings that is further taxing an already fragile market that is now seeing some of its ‘safe’ assets degrading. Investors could weather this if the government maintained its support of the global economy and markets; but this safety net is already being rolled in. As stimulus and emergency aid is rolled back, the markets will increasingly have to support its own weight. And, considering how high valuations have run and the lack of true fundamentals to support recent heights; the outlook is fragile indeed.

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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.