• Carry Interest Settles As Risk Aversion Consolidates Into Year End
• Will Investors Turn Back To Carry In The Near Future?
• The Dollar And Yen Compete For The Title Of Top Funding Currency
Year end is fast approaching; and seasonal factors are already having a clear impact on the liquidity underlying currencies and other markets. Thinned out markets may result in stalled trends and reduced liquidity; but it certainly does not mean that investor and lender confidence is improving. In fact, over the past few weeks, risk sentiment has arguably grown more optimistic; and the carry trade is reflecting the fading forecasts. The DailyFX Carry Index has pulled back over 150 points through the week to 20,527. A look at the recent fluctuations in this composite shows clear congestion after the incredible momentum through October. From a practical standpoint, this is partly a reflection of investor sentiment stabilizing (though the inability of the index to actually gain ground suggests forecasts for volatility and returns continue to deteriorate) as well as position squaring with capital flowing towards safe havens until the market returns to full capacity. When volumes pick back up after the new year, they will see carry (risk appetite) hovering near six-year lows, volatility pushing record highs and interest rates offering potential returns at levels that truly reflect a global recession.
Fundamentally, the end of the year is draining the market of liquidity as holidays and accounting considerations lead investors to square their positions and prepare for a new year of trading. This will likely support congestion as there is not enough of a market to sustain momentum; though volatility may actually remain exceptionally high. Looking ahead, when it is back to business as usual, investors will not come back to healthy markets. Uncertainty has actually grown over the past weeks thanks to growing risks to credit and plunging forecasts for the broad economic recession. For growth, most of the third quarter GDP numbers are in; and the pace has been set well below policy makers expectations. Far more concerning is the more timely, monthly data which is suggesting the contraction is actually accelerating – a forecast that is shared by many who expect the first quarter of 2009 to mark the worst of the economic cycle. Far more fragile is confidence behind lending and investing. This Friday, the US government deferred the potential collapse of the entire US auto industry by extending a $17.4 billion rescue package to GM and Chrysler. However, this is not a permanent solution for this sector, and other companies and industries from around the world are on the verge. In fact, brining the market’s attention back to the battered financial group, the Standard & Poor’s Rating Services actually downgraded the credit ratings of 12 major banks. On the other side of the equation, potential returns continue to shrink with the Fed and BoJ cutting rates to 0.25% and 0.10% respectively.
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: 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. |
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.
Learn forex trading with a free practice account and trading charts from FXCM.
