Risk Aversion Tempers after EURUSD Crosses 1.27 and the Dow 10,000 as US GDP and Policy Come into Focus

• Risk Aversion Tempers after EURUSD Crosses 1.27 and the Dow 10,000 as US GDP and Policy Come into Focus
• European and Chinese Troubles are Easy to Overlook When More Imminent Threats Exist
• The Balance of Risk / Reward Further Distorts as Expectations for Yield Drop to a 15-Month Low

The necessary fundamental ingredients are in place for a market-wide deleveraging of risky positions; and yet the bear move in capital markets and bid for the safe haven US dollar have dried up this past week. This comes as something of a surprise given the high-level event risk that has crossed the wires over the period that would theoretically support the dominant bias. So then, why is price action deviating from its fundamental bearings? In truth, the markets are not contradicting the bias that the speculative backdrop is providing; rather the influence of risk appetite / aversion has waned over the past two weeks. Last week’s temperance is not difficult to explain as the economic docket was exceptionally light and the financial headlines were exceptionally light. In fact, there were a few critical exogenous events that could have had a significant impact on investor sentiment and asset pricing; but when the masses aren’t paying attention – or truthfully, when the financial media isn’t paying attention – developments can be absorbed with limited impact on positioning. This week’s disconnect is more difficult to define. Major disappointments from US housing data and growing financial difficulties in Europe have indeed kept sentiment moving lower; but the gravity of much greater forthcoming risk is distorting conditions.

For the past months, the threat of a European or Chinese-sourced financial crisis has grown through dimming speculative forecasts and deteriorating economic data. That being said, it seems the market is content to believe the threat this posses the market is further in the future or is perhaps curable. However, the likelihood that European banks and sovereign governments will collapse under rising debt costs and China is overwhelmed by bad loans is leveraged significantly should the global economy stall. This is a scenario that comes into view with the trouble facing the US economy. As the world’s largest economy, the US is a proxy for the activity level of the entire world; and this particular player’s performance is quickly undermining an already questionable scenario of recovery. The first step is this Friday’s second reading for the 2Q GDP report. While the initial or ‘advanced’ reading is typically the figure that market participants care about; this time around, expectations for a large negative revision to the reading has leveraged speculation that the economy may actually fall back into a recession. The implications of such a scenario are immense. Growth is a vital element in a global recovery not only for propping up activity but also because the financial conditions are still unstable and stimulus is stretched. The market looks for clear signs that conditions are improving or deteriorating; and this is one of the least ambiguous events out there.

While the US GDP revision offers a specific event with which to establish fundamental conditions; the outlook global economic and financial health runs much deeper than a single indicator. Another growing threat that is established through the US is speculation that policy officials will be forced to further inflate stimulus to ward off a depression or some other equally frightening reality the world faces. This will ensure that the media is fixated on the commentary to come out of the Jackson Hole Symposium there Fed Chairman Ben Bernanke and other bright economic minds will discuss monetary policy. If this policy official’s outlook deteriorates or he hints at expanding support, the market will expect it to happen in short time. In reality, it could take some time to fully hammer out as election time approaches. Nonetheless, some may expect an extension of stimulus to produce the same rampant speculation that occurred in 2009 with cheap capital and a blatant safety net. Instead, investors will likely see this as evidence that the first round of stimulus didn’t work (why would the second); and growing government liabilities and interference will create financial distortions (or crises).

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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