special reports

Fear Is Easing But Returns May Not Compensate For A Rebound In Carry And Risk Appetite

Friday, 09 January 2009 23:45:51 GMT  |  John Kicklighter, Currency Strategist

Despite the return of liquidity with the first full week of trading, it is clear that the markets have yet to find a resolution on risk sentiment and the demand for yield. However, as long as bailout efforts fail to pick the global economy up from its recession and interest rates keep their course towards zero, risk appetite and the carry trade will hold near multi-year lows.

• Fear Is Easing But Returns May Not Compensate For A Rebound In Carry And Risk Appetite
• Are Global Bailout Providing Enough Of A Foundation For The Financial Markets
• Will The ECB Lower The Bar On Expected Returns For The Eventual Rebound In Markets?

Despite the return of liquidity with the first full week of trading, it is clear that the markets have yet to find a resolution on risk sentiment and the demand for yield. However, as long as bailout efforts fail to pick the global economy up from its recession and interest rates keep their course towards zero, risk appetite and the carry trade will hold near multi-year lows. Taking measure of sentiment over the past week, the DailyFX Carry Trade Index closed out the period not far from where it started at 21,251. However, intraweek, the index had actually extended its break to a new two-month high. This was quickly snuffed out though, suggesting the initial rebound may have been related to market participants reinvesting their capital for the new year, rather than investors seeking out outsized returns. As interest rates maintain their trend towards zero, investors are seeing little reason to attempt such sparse yields when risk is holding stubbornly high. The DailyFX Volatility Index is off its record highs; but at 19.7 percent, is still far above normal market conditions. 

This past week, the sense of balance that defines risk appetite and the health of the ever-present carry trade seemed relatively stable; but the fundamentals underlying the conflict were actually shifting deeper into pessimistic territory. While panic-induced credit seizures and tumbling asset prices have stalled over the past few months, the risk of another baking collapse or other destabilizing market event is still very high. From the world’s largest economy, data and the central bank’s assessment of activity revived fears that the worst of the global recession is yet to come. For scheduled event risk, the US docket printed a massive 524,000 drop in national payrolls last month. This brings the decline in employment for the year to 2.59 million – the worst contraction since 1945. What’s more, consumer credit through November dropped by a record $7.9 billion. While, this may be data from just one economy, it is nonetheless the world’s largest and likely an accurate reflection of what to expect globally going forward. And, considering consumer spending accounts for the greatest share of overall expansion, this data merely highlights the catalyst for the next shift in sentiment. Another important highlight for the week was the FOMC’s minutes, which heard the conservative central bankers warn of a “distinct possibility of a prolonged contract.” Policy makers are struggling to stabilize the market; and so far, the efforts have fallen woefully short. Reports suggest US President Bush will ask Congress for the second half of the $700 billion rescue fund; but will this money revive confidence amongst lenders who fear bankruptcy and consumers losing their jobs? The other factor to consider as time wears on is return. This past week, the BoE cut its benchmark to a record low 1.50 percent and the ECB is expected to follow suit next week. As the potential for returns grows more and more anemic, it will merely push back the moment when risk and reward are balanced enough to revive carry.

Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum

 

 

Risk Indicators:	Definitions:
	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.
	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 visa versa.   We use risk reversals on USDJPY as it is the benchmark yen pair and the Japanese currency is considered the proxy funding currency for carry trader.  When Risk Reversals grow more extreme to the downside, there is greater expectations for the yen to gain – an unfavorable condition for carry trades.
	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 the market prices influences 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 Bank of Japan will make over the coming 12 months. We have chosen the Bank of Japan as the yen is considered the proxy funding currency for carry trades. To read this chart, any positive number represents an expected firming in the Japanese 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 contract and carry trades will suffer.

 

 

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.

 

Question? Comments? Send them to John at jkicklighter@dailyfx.com.

Resources

• free demo account
• forex courses
• open an account
• forex stream
• free webinars