dynamic carry trade basket

Skepticism Over US Efforts To Recharge Growth Keeps Sentiment And Carry Under Pressure

Friday, 13 February 2009 20:46:20 GMT  |  John Kicklighter, Currency Strategist

Any sign of optimism that is able to bubble up in the markets recently has been consistently battered down by fading returns and the constant sense of risk looming over investors heads. And, holding to this bound sentiment, the rallies that equities, investment grade bonds and the yen crosses were able to develop just a short time ago were smothered this past week despite (or perhaps because of) the US government’s expansion of its Financial Relief Program and passing of a massive economic stimulus package.

• Skepticism Over US Efforts To Recharge Growth Keeps Sentiment And Carry Under Pressure
• Will US Treasury Secretary Geithner Encourage Global Stimulus Plans At The G7 Meeting?
• Another Round Of GDP Data Shows World Economy Set For A Deep Slump In 1Q 2009

Any sign of optimism that is able to bubble up in the markets recently has been consistently battered down by fading returns and the constant sense of risk looming over investors heads. And, holding to this bound sentiment, the rallies that equities, investment grade bonds and the yen crosses were able to develop just a short time ago were smothered this past week despite (or perhaps because of) the US government’s expansion of its Financial Relief Program and passing of a massive economic stimulus package. Nonetheless, the limbo in sentiment and congestion in carry interest that has developed since the massive plunge through October may finally be forced into direction if the patterns in USDJPY and the DailyFX Carry Trade Index play out as expected. Looking at the Carry Index, a clear descending wedge formation has developed and the most recent failure to recharge yield demand has further confirmed the dominant bear trend behind the market. The same pattern can be seen in USDJPY, though there is more pressure for a trend reversal with this risk-sensitive pair heading into the weekend. As the market prepares to take direction (and perhaps redefine its long-term trend), it is important to take note of condition indicators. Access to credit, options positioning and volatility have all shown improvement recently.

It is fitting that the technicals are demanding a resolution on risk trends just as fundamental activity is picking up. However, economics and policy do not exactly sync up to the potential for a bullish reversal seen in the yen crosses. Over the past week, the best potential catalyst for optimism failed to spark confidence in the financial system and economy. In an effort to speed up their response to the unfolding crisis, US Treasury Secretary Timothy Geithner expanded efforts to stabilize the domestic credit market (by proposing a joint private/public fund to absorb toxic assets and increasing the capital used to opening credit to consumers and small businesses) while the US Congress made its final tweaks on a $787 billion stimulus plan. These policies were initially met with skepticism as investors and lenders looked back to the failure of so many other liquidity injections, bailouts and guarantees before this round. On the other hand, it is notable that the market has not seen another wave of pessimism sweep over it during these months when capital and sentiment have been sidelined. Taking weight of the fundamental scales, we have seen growth readings plunge through fourth quarter readings; and forecasts for activity through the first half of 2009 look to tip economies into severe recessions (and some even speculate, depressions). On the other hand, there is evidence that the financial markets have stabilized, stimulus and bailout efforts have taken to the global stage, and a few major economies are already looking at recovery. However, at this point, the future lies with sentiment. Consumers, investors and lenders can turn the global economy around, but only if they work together.

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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.

 

Written by: John Kicklighter, Currency Strategist for DailyFX.com.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

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