The Dollar Takes Off and Dow Falters – Risk Appetite is on the Verge of Collapse

•    The Dollar Takes Off and Dow Falters – Risk Appetite is on the Verge of Collapse
•    When Sentiment Falls Apart Correlations will Tighten and Momentum Increase
•    How Over Extended are the Market and What are Fair Fundamental Values?

Any doubts that the market has forged higher without the support of stable fundamentals should be completely dispelled after this week’s sharp reversal. Even if this recent slump in investor sentiment doesn’t ignite into a true reversal of capital flows; the simple fact that the markets retraced so aggressively and in tandem stands as testament to the fear that lies just beneath the surface. What’s more, there are plenty of fundamental reasons to be concerned about the state of the markets or more precisely the conviction of those participants that drove the supposed high-yield / high-return asset classes to their over inflated levels. Among the long line of fundamental concerns that have slowly eroded the foundation of the most aggressive influx of speculative capital in history, we have non-existent yields, government efforts to restrain capital interests and the withdrawal of vital stimulus among many other factors. In gauging the threat of a significant retracement going forward, we need only pick our poison. Every major asset class has its own benchmark that is ready to suffer the ravages of risk aversion. In the Forex market, many prominent carry-based currency pairs have already marked critical breaks and reversals. The dollar has taken meaningful steps towards true recovery. Now, we await the clear break of the Carry Trade Index. The same conditions exist in more speculator-responsive markets. The Dow Jones Industrial Average broke out of a 300-point range for the first time in two months. In commodities, gold has overwhelmed a trend that has defined the metal’s bullish drive for more than five months now. These markets are at the very edge and require only the slightest gust of fundamental wind to transform a retracement into a true change of trend.

What could motivate investors to throw in the towel and either book profit or unwind failing positions? The most basic force at work will be fear itself. Should the more prominent benchmarks pitch into a clear downtrend, market participants will require little motivation to exit the market. Remember, it wasn’t long ago that the these markets suffered their worst crisis in modern history. While the collective memory of the markets is short; there is little doubt that traders will heed the warning signs and attempt to preserve any returns they have made over the past year. So, in these terms; all we need is a catalyst. There are plenty of sparks to push sentiment over the edge. The most recent threat to speculation comes in the form of government regulations and restrictions. These past two weeks, China has taken meaningful steps to limit leverage and aggressive speculation to prevent a potential bursting of an asset bubble. There is no argument to be made against the overextended market. Raising the reserve ratios, tightening loan requirements and other steps are no doubt reasonable; but their effectiveness in this stage of the game is too little, too late. And, China (the objective of a sizable percentage of the market’s most speculative funds) isn’t the only country bearing down on the volatile capital markets. US President Obama recently announced proposals that would limit the size and risk profile of the nation’s largest banks. This is a reasonable and direct step for a country that has been rocked by the failure of ‘too-big-to-fail’ firms; but there is little doubt that the side effects of such policy would be to reduce leverage and liquidity. Furthermore, these steps are being taken at the exact same time that the world’s policy makers are withdrawing the stimulus that has been so essential to market’s recovery to this point. As it was, there were concerns that speculators would be able to stand on their own when stimulus and guarantees were removed. Now they are looking at restrictions.

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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.