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Carry Interest is Rising But a Lack of Risk Doesn’t Translate Into Strong Fundamentals

By , Chief Currency Strategist
05 June 2009 01:01 GMT

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• Carry Interest is Rising But a Lack of Risk Doesn’t Translate Into Strong Fundamentals
• Central Banks Keep Rates Unchanged Yet Policy Officials Cautious
• Growth is Emerging as the Underlying Driver of Market Sentiment

Event risk was torrential this past week with a round of central bank rate decisions that covered both the most hawkish and dovish extremes of the policy scale as well as a slew of headline growth indicators. Naturally, one would expect extreme volatility and the establishment of new trends from this mix of fundamental fodder; but instead, we have seen exactly the opposite. The presence of so much event risk has frozen risk trends as market participants wait to absorb the releases rather than trading against a potentially influential event or piece of data. Since this week started with growth numbers on Monday and will end with US NFPs on Friday; there has is a consistent damper on swells in risk appetite. This has been seen across all of the capital markets. The S&P 500 has stalled below 950 just after hitting a seven month high; gold’s advance has seized within $10 from once again testing $1000/oz; and the Carry Trade Index has pulled back after a brief incursion to highs not seen since before the height of the financial crisis last October. It is not a stretch at this point, that this is merely a break within a rather momentous bull trend. However, looking back further than just the past three to six months, there is reason to believe that this advance could also be a correction in a much larger trend. The Carry Index is still nearly 28 percent off its record highs. It is unlikely that we will see the level of sentiment that preceded the crisis for a long time.
 
It is hard to be skeptical in a bullish market – much harder than doubting a long-term decline. Investors are hard-wired to buy assets as they find their way into the market. However, there is a difference between an influx of capital into the market and the appreciation an asset enjoys when speculation supports its strength. Sidelined money is returning to a market space that has shrunk (reducing the opportunities for liquidity) and the pool itself has been severely diminished through the market collapse and global recession of the past few years. Eventually, the market will bear as much of the risk-seeking capital as participants are willing to invest (unless another crisis unexpectedly arises); and then fundamentals will to come back into view. The burden of risk has not completely dissipated. The grip of recession is still tight (even if there are signs its pace is slowing) and the eventual recovery will be fraught with difficulties. Upon the recovery, government’s will have to unwind their aid, which restrict credit and saddle the market with toxic debt that is currently being held on the central bank’s accounting books. Widening rates on US mortgages and TALF loans are already showing signs of strain. What’s more, a revival of investment will require attractive returns. With central banks maintaining interest rates near multi-decade lows and keeping open the option to further loosen policy and expand quantitative easing; it is clear that there is little hope to see a significant increase in yields anytime soon.

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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.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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05 June 2009 01:01 GMT