As Risk Continues to Recede, the Dollar Rallies and Dow Tumbles

•    As Risk Continues to Recede, the Dollar Rovers and Dow Tumbles
•    Financial Cracks Multiple: Greek Deficit, Japanese Credit, UK Banks
•    A Drop in Sentiment Comes amid a Recovery in Economic Activity

It may seem a contradiction in theory; but in practice, a general slump in risk appetite can occur while economic indicators are pointing towards a slow but steady recovery. This is the scenario that is currently playing out; and the dichotomous situation is a reflection of how markets can grow to be over- or under-valued. What we are seeing at this stage in the game, is the adjustment of one to the other. Under different circumstances, speculative interests could have been held up by an influx of investment capital long enough for yields and growth forecasts to catch up to the market’s prevailing level of ‘fair value.’ However, as it is, the recovery in economic activity and expected returns is running at too measured a pace to keep up with capital markets that have forged their most aggressive advance on record. And, considering the vast number of financial cracks that are opening up just beneath the market’s seemingly smooth surface, there is ample reason for traders to worry. And, worry they have these past few weeks. Last week, the Dow Jones Industrial Average and the US dollar made their opposing moves as the winds of risk aversion started to pick up. The former has definitively cleared a two-month, 300-point rising trend channel in a nearly 6 percent plunge that has ushered the benchmark to two-and-a-half month lows. As the speculative capital is drawn out of relatively risky positions, the capital that was borrowed to fund these outlays is being repatriated. With a benchmark market rate that has held at a discount to event its Japanese counterpart (a historical funding currency) since late August, the US dollar was a prominent source of funds for leverage and loans. As fading sentiment encourages this reversal in capital flows, we will see the greenback advance. However, long-term traders will ask: how long will the dollar be a funding currency?

Despite the recent pull back in yield-bearing and risky positions, there is still a measure of doubt that this is not merely a mild correction. Technically, this is an easy argument to make. From a fundamental perspective, on the other hand, the evidence is there for an extended retracement as the markets seek out a fundamentally justified level of fair value. The initial catalysts for the current correction were broad and varied – helping to overwhelm the comfortable rut the steady build in risk appetite had dug out throughout 2009. Perhaps the most poignant tremor was the steps China took to cool its rapidly growing economy and markets. Chinese Policy officials are keenly aware of the asset bubble that has formed with new loan growth surging to a record and benchmark capital markets leveling off after soaring post-global crisis. Whether they are able to avert a bursting bubble is a serious question market for the global markets. In the meantime, other regions are facing their own troubles. After US 4Q earnings disappointed, President Obama proposed limits be put on the size and risk-taking allowances of the nation’s largest banks. While such a step may help to correct the ‘too-big-to-fail’ problem; it will also reduce market volatility and liquidity. Europe, the traditional ‘alternative’ to the United States has seen its clout fall as well. The Greek deficit is only one of the prominent troubles that the Euro Zone faces. Economic struggles and budget shortfalls will either weigh the region down or encourage a country to abscond. Either scenario is a concern. And, in Japan, the lost decade seems to never have ended. The government has said that it may extend its emergency stimulus programs; but that hasn’t seemed to stoke the fires of recovery or fend off deflation. With this in mind Standard & Poor’s downgraded its outlook for the nation’s credit. If these are obvious problems playing out now; what issues have not yet been uncovered or come under the scrutiny of the markets?

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

Risk Indicators:	Definitions:
	DailyFX Volatility Index      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.
	USDJPY 25 Delta Risk Reversals 3 Month       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.
	Reserve Bank of Australia Expectations      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.