A Return of Speculative Liquidity Doesn’t Forge a Meaningful Breakout for EURUSD or the S&P 500

• A Return of Speculative Liquidity Doesn’t Forge a Meaningful Breakout for EURUSD or the S&P 500
• European Financial Outlook Consistently Bearish, But Will the Market Come Around to this Reality?
• Asia’s Threat Profile to the Globe Rises as China Moves Up its Data Release, Markets Balk at Japanese Stimulus

For those familiar with seasonal trends in the financial markets, this past week carried a significantly probability for not only volatility but also trend generation. The second trading week of September marks the return of US-based liquidity after an extended holiday weekend; and it is also considered the end to the summer doldrums. The return of speculative interest was tangible through the relative level of volatility in the markets; and the timing for this structural development was well coordinated with fundamental developments (troubles in Asian, European and the US are becoming increasingly apparent). Despite these optimal conditions for a significant development, however, the market as a whole notably refrained from a meaningful breakout and trend development. The chop was perceptible across the asset spectrum. At the high-end of the speculative sensitivity scale, the S&P 500 bled off the moment of the previous week and further held to the congestion of the past months. For the macro FX market, EURUSD made little effort to move out of its one-month, 300-pip range. Even gold – more highly attuned to long-term uncertainties and one of the few assets to deviate from the otherwise universal correlation across capital markets – would be knocked off its six-week bull trend before reaching record highs.

If all the proper speculative catalysts were in place, why wouldn’t the markets spurred to the highly-anticipated breakout? The most frank answer is: a lack of conviction (be it bullish or bearish). We have seen a number of developments over the past weeks and months that have significantly altered the outlook for economic activity and the potential for returns. Yet, the ominous clouds are still on the horizon. Most market participants are reactive rather than proactive in their investment decisions – hence the existence of extreme volatility, crashes and regulation like price limits. Therefore, even as the outlook deteriorates, investors will hold out until a build or unwinding of risky positions forces a decision. This is an interesting dynamic whereby the markets often generate their own trends – without the instigation of a particular event or piece of data. However, that shouldn’t diminish the importance of actual fundamental developments. While they may not lead to an immediate shift in price, the underlying valuation continually shifts; and speculative interests will eventually rectify the gap.

Gauging the potential for a significant move going forward, we have plenty of ammunition for a meaningful correction – and generally it supports an unwinding of risky positioning. The most frequent trouble spot, Europe, would garner the attention of both the speculative crowd and the financial media this past week. Among the stories that raised concern, Ireland’s ability to afford its bailout of Anglo Irish Bank was put in the spot light and the government subsequently proposed a plan to split the firm into ‘good’ and ‘bad’ components (the same approach was considered for Lehman and has been entertained for other nations). There was also the news that Greek banks had borrowed an astounding 96 billion euros from the ECB in order to maintain solvency and speculation that Basel III could force European banks to raise additional capital to ensure stability. The trouble isn’t just with the Europe though. Trouble is far more widespread. Asia is growing as a threat to global stability. China moved up its economic release schedule, leading many to believe the central bank is planning to raise rates in a further effort to curb excessive lending (that is in turn feeding an unsustainable real estate and speculative bubble). And, then there is Japan which is struggling to balance a recovery with ending deflation while struggling to halt the yen’s appreciation and generating little confidence by announcing another 915 billion yen stimulus plan. Finally, there is the general concern about the cooling of the global recovery which would further expose existent troubles.

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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