The Euro and Commodity Currencies Rally as ECB Guarantees, Chinese Data Quiet Crisis Concerns

• The Euro and Commodity Currencies Rally as ECB Guarantees, Chinese Data Quiet Crisis Concerns
• Speculative Interests follow the Dow Higher, Fundamental Concerns Rest with Risk Premiums
• Traders Watch 10,000 for the Dow and 1.2120 for EURUSD for Cues on Risk Appetite / Aversion

 Over the past six months the principal fundamental concern behind the bear market has evolved. What was originally a mere retracement on a overextended 2009 rally would evolve into fears over the health of the outperforming economies (i.e. China), then uncertainty surrounding sovereign credit risk with ballooning deficits and finally the specific concerns that the next financial crisis could spread from the European Union. Naturally, when confidence improves for the most unstable dynamic for the financial markets, investor sentiment will recovery in kind. And, when all of the major issues are answered at once, the reaction is far more dramatic. This is the scenario we were presented with over the past week: the euro’s existence has solidified; China’s economic data outperformed; sovereign ratings have been steadied with austerity and stimulus measures; and the capital markets themselves have bled off a significant portion of the speculative buildup through the previous year. With this fundamental health trickling down to the speculative masses, the response from the markets has been significant. The most recognizable improvement comes from the Dow Jones Industrial Average’s spectacular performance on Thursday whereby the index put in for its biggest rally in two weeks and subsequently rose above the psychologically important 10,000 (a level that is considered the threshold to a more committed bear wave for the equities market). Other capital markets have performed with similar zeal through the week. The benchmark 10-year Treasury note yield has risen 14 points and NYMEX-based crude oil futures have rallied to their highest levels in a month north of $75.50. In the currency market, the performance of yield-heavy pairs like AUDUSD and NZDJPY is obvious. More sober is the rebound from EURUSD from four year lows. Having broke a steady selling trend, the pair is now looking to once again overtake its historical midpoint at 1.2130.

The reason EURUSD makes for a better reading on the currency market’s fundamental health is that its roots run deeper than a highly volatile response to the demand or lack-there-of for yield. For this particular pair – the most liquid in the currency market – its performance is a smoothed reflection of the concern over the financial uncertainties that are always present in the market. Even in the best of times, there are lingering threats to stability and capital appreciation. It just so happens that these concerns are more prevalent nowadays and the grandest of these threats can be traced back to the euro itself. Having just recovered from the worst financial crisis in modern history this past year, the masses are highly sensitive to the likelihood of another global shock. For months now, Greece and various other European Union members have been at the center of this renewed uncertainty. Should one of these economies default on their debt, it would breech inflexible rules for the region which could send the region into a crisis and perhaps even trigger a slow death for the currency itself (the second most prolific in the world). Today these fears were diminished significantly with the ECB’s vow to continue to buy bonds and thereby provide member government’s with liquidity and the announcement that three unlimited fund facilities would be performed over the coming three months. This – along with the EU Presidents promise to increase the size of the financial rescue plan should conditions tax the current 750 billion arrangement – has significantly diminished the threat of a financial implosion. On the other hand, all is not good. The side effects of the fiscal extensions Europe is putting itself under is greater sovereign credit risk. The US, UK, Japan and others are under similar pressure. Furthermore, China and the outperforming emerging market economies are still at risk of stalling and pitching into a tail spin due to debt obligations. Yet, where sentiment goes, so does the market.

 

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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.