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Risk Appetite and the Euro Rise but is this a Function of Fundamental Strength or Speculative Interest

By , Chief Currency Strategist
18 June 2010 01:54 GMT

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• Risk Appetite and the Euro Rise but is this a Function of Fundamental Strength or Speculative Interest
• The Dollar’s Role as a Safe Haven Skewed by Fundamentals an Overextended Rally
• Interest Rate, Growth Expectations Slowly Deflating as European, Emerging Market Economies Cool 

The burst of life the speculative markets showed last week has proven itself more robust than what many had expected. A number of financial benchmarks for investor sentiment have established a second week of optimism along with noteworthy breakouts on a technical basis. What has been the foundation for this strength? Aside from a few positive announcements and indicators, the real source of this speculative climb is a lack of discouraging news. In the two months preceding the current upswing, confidence progressively deteriorated as fear that Greece could trigger a financial crisis for the European Union evolved into panic that such an event would in fact have global repercussions (similar to the turbulence of 2007-2008). Naturally, with every analyst and journalist looking for the region’s defects and shortcomings, the seams would start to show. However, the hazards just below the surface would be assessed quickly. The underlying fundamental troubles take time to develop and additional pressure from the market. We are now at the point where the easy stories have been spent and the tension of fear has diminished. This leaves those traders positioned for bearish developments with the decision to take profit or stick it out; while opportunists see an occasion to possibly reenter a speculative market at a cheap price.

Naturally, those markets that were the most responsive to the initial reversal in sentiment would be the first (and most susceptible) to reverse course when sentiment leveled off. Equities have been one of the most reactive asset classes. The Dow Jones Industrial Average and S&P 500 both held notable support (10,000 and 1,050 respectively) and have since retraced nearly 50 percent of their losses in April and May. The growing speculative interest in commodities has driven crude to an impressive reversal that has covered nearly two-thirds of the initial plunge instigated in May. Yet, going to the source, it is EURUSD that has offered the most interesting reaction to the tides of sentiment. Seven months of steady depreciation has integrated the influence of growth, interest rate and financial stability concerns. This pair’s reversal has been relatively slow (compared to equities performance) but measured. What’s more, given the incredible tumble the euro has put in this year; a retracement can perhaps extend longer than what a general rebound in risk appetite would warrant. It is further the case that the euro itself can benefit from the dollar’s own shortcomings. The greenback has seen growth expectations temper and interest rate forecasts evaporate. So, while the dollar loses ground through economic means, its primary counterpart can dampen its own pain should uncertainty return.

However, for investors, a modest buffer or outlier in a bigger trend in risk will matter little. The general bearing on risk appetite is the primary concern for carry interest and positioning for speculative gains. Looking above the fray of fickle risk appetite, there is plenty of reason to remain cautious over the health of the global economy and financial markets - especially when it comes to the market’s evaluation of the two (as the market more often than not overshoots the mark and ends up correcting in dramatic fashion). The immediate concern is the health of the European Union. Greece has vowed it would not restructure its debt and the warning of a Hungarian default has been recanted. Yet, there are many cracks in the façade. The most recent issue is speculation that Spain will be forced to seek its own EU/IMF rescue package. Beyond Europe, we also have to consider China along with a number of Asian countries is struggling to deflate overleveraged property markets without sparking a panic; and sovereign debt risk will rise further should speculative interests buckle and stimulus is withdrawn either too quickly or too slowly. 

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Risk Indicators: Definitions:

 

 

 

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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.

 

 

 

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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 vice 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 pair's 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.

 

 

 

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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.

 

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


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.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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18 June 2010 01:54 GMT