Sentiment Behind the Dollar and Markets on the Verge of Breaking, but Which Way?

•    Sentiment Behind the Dollar and Markets on the Verge of Breaking, but Which Way?
•    Credit and Financial Market Risk at Lows not Seen since before the Lehman Failure
•    How far off is a Rebound in Global Interest Rates?

The financial markets have yet to establish a clear trend through the first week of the New Year. In fact, currencies, equities, commodities and nearly every other risk-sensitive asset class has gone without a clear bearing on underlying sentiment for nearly two months. However, this fundamental meandering will not likely last for much longer. We have come to this point of indecisiveness through two of the most aggressive swings for the capital markets in recent history. The initial plunge in the markets was a product of pure fear for a financial crisis that would only be rivaled by the Great Depression. Naturally, the next prominent trend was the recovery from the depressed levels post panic; and the reversal was arguably the largest in the history of modern markets. Alas, such a drive cannot last forever. Eventually a level of fundamental equilibrium has to be met; and considering the lack of meaningful returns along with the presence of lingering risks that are sure to be exacerbated as the world’s governments withdrawal their unprecedented stimulus safety net, that moment may be closer than many investors may be willing to admit. On the other hand, a clear and defining bearing on sentiment doesn’t have to be defined immediately. Irrationality is an essential trait of the financial markets; and with many traders waiting to see what will happen with their capital gains to this point while a glut of funds remain on the sidelines, extremes can be distended. Yet, when the ball does start rolling in favor of optimism or pessimism; the signs will be clear. Considering the incredible correlation that developed between the dollar, the Dow Jones Industrial Average, gold, and fixed-income indexes over the past two-and-a-half years; when the winds pick up, all the markets will be trending in tandem. But, in the past two months, it has been the stock benchmark that has maintained its direct link to the under current (even during its low tide) and here is where we will look first.

Now that we know what signs to look for when sentiment does start to fire back up; what will be the fundamentals that drive and sustain a true trend? In reasoning out the push and pull behind growth, confidence, investment potential and many other conditions essential to activity; we are deliberating on a more elemental question: which direction will the market take. The larger trend behind the market remains the bullish advance that defined 2009. However, this unprecedented influx of speculative funds was a temporary market aberration that was born out of the financial crisis that preceded it. At this point, there is a dearth of loose, speculative capital that can be readily deployed to chase the promise of quick gains. Investment dollars that were not put to work during last year’s rally were held back until fundamentals justified it or yield income recovered or in difference of the possibility of risk appetite collapsing under its own weight. Conditions have not improved much in the past months. Speculative forecasts for growth and returns have tempered, stimulus is being rolled back, and global rates are far from their own recovery. In all this, the argument that risk appetite has exhausted itself becomes clear. Traders have been responsible for the bulk of the markets’ recovery rather than stalwart investors. And, when traders catch wind of burgeoning risks or feel it is time to take profit; they are concerned with protecting their own capital rather than system.

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.