Risk Appetite Offers Mixed Signals with the S&P 500, Dollar and Gold All Diving Simultaneously

• Risk Appetite Offers Mixed Signals with the S&P 500, Dollar and Gold All Diving Simultaneously
• Is the Dollar Still an Ideal Safe Haven Currency as Growth, Rate Forecasts Temper?
• Chinese Growth and European Financial Health Present Critical Deficits for Investor Sentiment 

The developments in the markets and risk appetite were highly volatile and somewhat unusual. There is little argument to be made against the claim that risk aversion has picked up considerably over the past week. Most of the risk/growth-linked asset classes have contracted sharply while the fluidity of the credit and financial markets started to stress. Considering the fundamental developments that have arisen in recent days, such an outcome is not unexpected. On the other hand, not all of the benchmark assets have performed as would be expected. In fact, two of the most renowned and unflappable safe havens have actually deviated from their normal track and in turn established a extraordinarily bizarre positive correlation between some of the most unlikely of bedfellows. To illustrate the remarkable developments just today (Thursday), we have seen benchmark equities index tumble alongside the US dollar and gold. Savvy investors know this is unusual considering the greenback and gold are safe haven assets that typically appreciate when typical capital markets fall and speculative capital seeks shelter. A short-term divergence – even one as volatile as that seen today – can be chalked up to a temporary anomaly. Indeed, a demand for liquidity could have set gold tumbling and temporary reprieve for the euro could have led to the dollar’s slump. Yet, should this divergence turn into the norm; we could be seeing a fundamental shift at work. 

While we await the verdict on which assets are ideal safe havens and which are the best investment securities, we should look at investor sentiment itself. While both the dollar and gold have corrected sharply in the past 24 hours, both are still very close to their respective highs (the former near a four-year high and the latter a record). Recently more sensitive to the ebb and flow of risk however are the players on the other side of the spectrum. The US equity indexes have plunged this past week; but the real bearish sentiment comes from the fact that they have all cleared major technical support levels and tested new lows for the year. There is always a point at which momentum takes over in a market and selling pressure is self feeding. Equally volatile are the performances of high-yield assets. But it is the gradual and consistent progress made on risk premiums in various corners of the financial market that should truly concern (and remind us of why we should not be surprised we have gotten to where we are now). Risk premiums in junk bond spreads and credit default swaps offer a clear look into risk; but the foundation for uncertainty can be traced back to benchmark Libor rates. The interest rate at which banks lend to each other hand climbed aggressively this year; and some (the euro) continue to advance.

To assess where the current effort to unwind risky positioning is close to its exhaustion point or whether it could very well accelerate going forward, we look at the fundamental drive behind this shift in sentiment. The fear and greed of the mob is not easily defined; but it is not too difficult to catch its bearing and take note of those events that can further catalyze its development. Aside from the threat of losses on capital positions feeding a selling cycle; the greatest threat to investors is the financial situation in the European Union. With the expiration of a pivotal lending facility (12 months and 442 billion euros), we have seen the true character of the region’s banking community. A 132 billion euro demand for a fill in three-month program seems modest; but the follow up with a 112 billion euro bid for six-day loans shows us that liquidity is significantly strained. Another issue that is building momentum is the expected results for stress tests on EU banks. Should some firms refuse to release details or the numbers come across as weak, a whole new problem will develop. And, then there is the government’s funding needs to consider. Should we move beyond Europe, we also find China is visibly slowing, there is an imbalance in providing stimulus versus reining in deficits and key economies (the US) are starting to stall.

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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.