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Risk Appetite Soars, But the Currency Market Waits for Its Own Critical Break

By , Chief Currency Strategist
24 July 2009 03:42 GMT

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• Risk Appetite Soars, But the Currency Market Waits for Its Own Critical Break
• Earnings Uneven After a Strong Start With Goldman Sachs Record-Breaking Figures
• As the Accounting Season Passes, Traders Now Look to Growth to Support Bullish Sentiment

Over the past week, we have witnessed an aggressive shift in market sentiment. Fueled by impressive second quarter earnings data, risk appetite has left its imprint on all markets. However, whereas equities have managed to push to new multi-month highs, we have seen currencies hold off from taking that last step towards an out-right bull trend. Now, with corporate accounting figures running dry and growth indicators taking over the headlines, we will see the primary fundamental driver for the markets change; but does this also mean a change in direction? Whether destined to make a late break or tumble into an aggressive retracement; the currency market is at a turning point for sentiment and likely trend. Looking at the Carry Trade Index, short-term momentum is clear; and more importantly, the rally of the past week fits into the gradual bias that has been developing since the beginning of February. This composite (made up of the those pairs with the largest interest differentials) has in fact tested highs not seen in nine months; but we have not yet fully cleared the highs set in early June. This is a good representation of not only those pairs that are clear carry trade fodder, it corresponds to the state of the majors as well. The most liquid pair in the market, EURUSD has similarly held back from overtaking 1.4340 to forge new highs for the year. The circumstances are the same for GBPUSD, USDCHF and AUDUSD. However, we have yet to determine whether this is a temporary situation or a prophetic pause. With the Dow closing above 9,000 and crude oil closing its seventh consecutive daily advance, something has to give.
 
Monitoring the fundamental path of the market’s recent rally, it was relatively clear that a strong start to the second quarter earnings season was the primary motivator for the sudden reversal in optimism. In the first wave of releases, a record profit for Goldman Sachs and strong performance by two blue chips initiated the turn. Since then, the market has seen a considerable number of better-than-expected reports. On the other hand, there have been just as many disappointments. Determining whether or not we are looking at a genuine revival of the bull trend that has dominated price action for much of this year requires a critical analysis of those forces underlying the rally. Much of this recent rally can be attributed to speculation. For the past six months, investment trends have drifted higher thanks to an influx of capital into the traditional asset classes and the vague consensus that the worst of the global recession has passed. What the earnings data contributed was confirmation that the recovery in economic activity was showing through at the corporate level; and therefore, the foundation for production, employment and earnings was in place. What is being overlooked though is that, like the economy itself, earnings data confirms the corporate sector is stabilizing – not that it is in fact growing. Regardless, the earnings season is already on the decline; and a new catalyst will likely have to be found. This sets GDP data for the heavy lifting

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

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Risk Indicators:

Definitions:


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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.

 

 

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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 AUDUSD as global interest rates have quickly fallen towards zero and the lines between safe haven and yield provided has become blurred.  Australia has a historically high and responsive benchmark, making it more sensitive to current market conditions. When Risk Reversals grow more extreme to the downside, it typically reflects a demand for safety of funds - an unfavorable condition for carry.

 

 

 

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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.

 

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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.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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24 July 2009 03:42 GMT