Fed Stimulus Efforts Revive Fear and Dollar Bidding, European Economic and Financial Health the Next Step

• Fed Stimulus Efforts Revive Fear and Dollar Bidding, European Economic and Financial Health the Next Step
• The Dow and EURUSD See a Sharp Reversal in their Steady Bull Trends as Sentiment Degrades
• China’s Financial Troubles are No Longer Theoretical as Government Reigns in Stimulus

Investor optimism has clearly deteriorated this past week. However, we are still at the point in the speculative transition where the markets can revive trend or lead to a new trend. The severity of the correction in benchmark risk-based asset classes can be partially attributed to the collapse of a one-sided market. In the two-months preceding this week’s slump, the buildup in ‘risky’ positions was a consistent one over the span of two months. Eventually, the buy orders would dry up; and more importantly, the lack of fundamental support for the climb would encourage those with exposure to book profit sooner rather than later. And, when this event took place, it did so to dramatic effect. Taking stock of the performance at the point of reversal, we first note that the FX market’s most liquid currency pair, EURUSD, put in for its biggest daily loss since October 29, 2008. It is important to recall the market conditions from this period: the fall of Lehman Brothers had pushed the global financial markets into the height of the worst crisis in generations. Under a slightly more controlled feeling of panic, the S&P 500 would tumble 2.8 percent while crude fell 2.9 percent. What is important to derive from this performance is how much of this contraction is a function of fundamentals and how much is it a technical move.

Two months of steady risk building will inevitability lead to correction; but an aggressive, ‘V’-shaped reversal is still unusual. But, if the motivation for a reversal of the magnitude we have seen this week is based purely on the need to book profits and balance trade books; the durability of the move will be reserved to the initial retracement. If that is the case, the balance has already been restored. Alternatively, if the preceding build up contradicted the fundamental backdrop in the initial advance and sentiment finally collapsed under its own weight, the reversal can extend into a meaningful trend. In fact, we have seen both the US and Chinese economies (two of the world’s largest) mark notable deterioration through economic data. At the same time, financial conditions in many of the world’s hubs have closed in upon defaults and crises. The most recent developments to the fading picture have been the worst. The FOMC this week downgraded its outlook for growth and announced its intention to put a floor in its stimulus withdrawal. The impact that weaker expectations for economic activity would have on speculative interests is obvious; but the implications of a hold on stimulus is debatable. On the one hand, stimulus is a safety net for investors and was a major element in the 2009 market rally. At the same time, investors know that stimulus is both temporary and leads to distortion in financial conditions – perhaps a bigger problem for markets.

Stalled growth and financial activity in the US is important; but true fear is born from concern that such a deterioration will spread to the rest of the globe much like the crisis of 2007-2008. The backdrop of over-leverage and constricted liquidity that defined conditions during this last crisis remains to this day. The difference between then and now is that the world’s governments have already overextended themselves in stabilizing the markets; and just when the market’s have grown used to this support, they have come under pressure to rein in stimulus or face long-term financial troubles on a national level. This gradual shift is exposing two particularly fragile economies that could catalyze the next catastrophe: China and the Eurozone. The head Chinese banking regulator has called on its lenders to move off-balance-sheet assets onto their books and set a worst case scenario for stress tests of a 60 percent drop in residential housing prices. There has long been talk of an asset bubble in this leading investment economy; but few have actually positioned themselves for an actual failure. The markets seem to be more accepting of trouble developing in Europe. With Spain hinting at a reversal in its austerity measures and Slovakia voting to not support the Greece bailout; the cracks in the effort to stabilize regional finances is clear. Add to this signs that the economy is slowing; and another round of panicked media attention may be in order?

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 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 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.

Highest And Lowest Yields:

The Interest rate used to benchmark the currency basket is the 3 months Libor rate

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

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