Can NFPs Provide a Clear Bearing on Risk Appetite Where Volatility Alone Fails?

• Can NFPs Provide a Clear Bearing on Risk Appetite Where Volatility Alone Fails?
• European Policy Authorities the Latest to Expand Their Support as the Global Outlook Deteriorates
• A Sharp Increase in Risk-Based Markets Offers a Glimmer of Hope after a Month of Declines

For more than a month now, those market-based benchmarks that so perfectly characterize investor sentiment have slowly depreciated. This hasn’t been an aggressive shift, more like a capitulation that shows the certainty of high correlation across different asset classes. However, it is the absence of significant momentum that opens the door to a reversal that can easily be coaxed by a wave of risk appetite. Just such a standout performance would take place this past week as the S&P 500 and EURUSD marked their biggest respective rallies in nearly two months. However, we are left to question whether this is a general reversal in bearing and conviction or merely a correction that is naturally derived from low range, high volatility conditions. What is needed is a fundamental catalyst to either confirm or contest the tentative revival of investor confidence. It just so happens that this Friday’s docket carries one of the most consistent market-moving macroeconomic indicators the fundamental ranks have to offer. However, there are very significant hurdles this indicator must overcome to have a meaningful, short-term impact on price action.

Historically, the US monthly nonfarm payrolls (NFP) report is one of the most influential economic updates the market absorbs. Fundamentally, its sway isn’t difficult to appreciate. At its root, employment is the foundation for consumer confidence and spending. Further, personal consumption in the US is the largest component of economic output (at 70 percent) for the world’s largest economy (which in turn acts as a proxy for the rest of the world). And, if we were simply to poll speculators, we would likely find that they follow and react to the data simply because it has so consistently moved the market in the past – and therefore becomes a self-fulfilling prophecy. However, the days of blindly event risk for short-term volatility seem to have passed. In more recent months, initial concerns that the global economy was leveling off in its recovery have evolved into growing speculation that a double dip recession could be in the cards. With that general concern in mind, a 105,000-person drop in net payrolls (the current consensus) when the jobless rate is hovering not far from a 26 year high (at 9.5 percent) is certainly difficult to construe as promising. And, while there is something to be said about particular meaning of private payrolls and the shock-value of a month-over-month surprise, it does little to offset a growing consensus that the global economy and market are sliding back into malaise. Another unusual set of circumstances will weigh on the market’s reaction this round of event risk (for better or worse). By the time the labor data hits the wires on Friday, the market is quickly winding down as the weekend liquidity drain approaches. This time around, the masses know that the US markets will be closed for Monday for the extended Labor Day holiday weekend. With banks running on skeleton crews, liquidity will be especially light.

So, if the US employment data will miss its opportunity to define the larger trend of confidence or fear in the capital markets; where will the market look for its bearings? After the lull in market depth is evened out next week; the global docket is still exceptionally light. Some would think this is a recipe for quiet markets; but it can actually be exactly the opposite. Oftentimes, the preponderance of heavy event risk can trip up the development of a meaningful trend by dissuading investors from placing trades ahead of a potential burst of volatility (much like we have discussed happens with the NFPs). Yet, the calendar clear of heavy-weight economic releases; underlying trends can more easily develop momentum and a fundamental following. What are the top concerns going forward? Speculation itself is the most heady driver as it has a tendency to build upon itself. With Fed, BoJ and ECB extending stimulus there is room for conjecture.

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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