A Steady Build in Risk Appetite Belies a General Lack of Conviction

•    A Steady Build in Risk Appetite Belies a General Lack of Conviction
•    How Long with the US Dollar Maintain its Status as a Safe Haven Currency?
•    The Greek Deficit, Japanese Financial Stability and US 4Q Earnings Just a Few of the Lingering Problems

Another week has passed without a clear bearing on underlying investor sentiment. There are those that will say risk appetite is on the rise and they will point to a steady advance in equities and measured retreat for the safe haven US dollar; but these developments are far from the quality one would expect if indeed capital was chasing greater rates of return with limited concern of the risks that lingered in the background. There are in fact too many threats to stability that are out in the open and expected returns are still severely limited as the dividends, coupons and other sources of financial income are limited by the shallow economic recovery that has developed to this point as well as an overall lack of revenue and lending at the business and investment level. Does a reasonable outlook into the near future call up an end to investors’ doubts and caution; or is it more likely that speculative interests will falter before more stable sources of capital find their way back into the capital markets? Time is the only proof of such a forecast; but in the meantime, the market’s level of activity provide us a few clues into where sentiment will ultimately turn. Looking to the benchmarks of risk appetite, we have seen a steady (almost preternatural) rise in key benchmarks. Almost shocking in its measured ascent, the benchmark Down Jones Industrial Average has climbed to fresh 15-month highs; and yet the index has not strayed outside a 300-point band. The dollar is much the same. While there have been greater instances of short-term volatility, the funding currency has nonetheless been held under water until FX traders see irrefutable evidence that the currency is moving up the risk spectrum and no longer represents the optimal currency to borrow funds in and ultimately invest elsewhere.

For a fundamental bearing on the market, the threats to the recent period of tranquility aren’t even obscured by an impressive rally in capital markets (feeding the promise of capital gains) or the promise that policy authorities are ready to step in at a moment’s notice to prevent another potential financial disaster. Over the past weeks and months, the world’s central banks have heeded the tentative positive turn amongst the largest economies and the notable return of speculators to occasion the necessary rollback of fiscal support. The Federal Reserve has removed support from its major financial institutions, the ECB has called an end to its unlimited loans and the BoE has capped its bond purchasing program. These are measured efforts; but collectively, there is little doubt that the authorities are slowly withdrawing the safety net that has encouraged confidence amongst investors and speculators that would have otherwise avoided the risk-prone markets. What’s more, there are a number of key concerns that are building in prominence and could soon dissuade the market enough to spur a round of profit taking that in turn catalyzes the much needed correction. Topping headlines recently, Greece is suffering from significant financial troubles that could in fact jeopardize not only its sovereign credit rating but also its place in the European Community. Should the country leave the group, it would no doubt generate massive shockwaves for the currency market and specifically the euro. Another issue that perhaps hasn’t reared its head yet is the fourth quarter earnings season in the US. Over the past few quarters, income statements have been a source of confidence. However, record earnings have been more than partly influenced by cost cutting and government aid. Losses and write downs could easily shake flagging investor confidence.

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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.