dynamic carry trade basket

The Global Recession Deepens But Risk Appetite May Hold Out For The US Stimulus Plan

Saturday, 07 February 2009 02:13:36 GMT  |  John Kicklighter, Currency Strategist

Through the end of this past week, there was a notable rally in the Aussie and Kiwi dollars, a surge in equities and a plunge in the Japanese yen. Is such a broad-based move a sign that risk appetite is returning? The trend in growth and interest rates would suggest no; but fading uncertainty may suggest otherwise.

• The Global Recession Deepens But Risk Appetite May Hold Out For The US Stimulus Plan
• Fading Growth, Anemic Returns And Lingering Threats To The Financial System Persist
• Is The Massive US Economic Stimulus Package The Key To Confidence?

Through the end of this past week, there was a notable rally in the Aussie and Kiwi dollars, a surge in equities and a plunge in the Japanese yen. Is such a broad-based move a sign that risk appetite is returning? The trend in growth and interest rates would suggest no; but fading uncertainty may suggest otherwise. From the currency market, the tentative rebound in yield appetite (or drop in fear depending on how you look at it) was clearly reflected in key crosses. All the liquid yen crosses marked substantial breakouts followed by rallies – perhaps more a reflection of waning risk aversion. But the rally in both the Australian and New Zealand dollars was clearly a sign that demand for return was playing a role in the market’s actions. Stripping the influence that any individual currency may impart on our reading of risk, we can see that carry similarly had a very strong end to the week. After slipping to yet another six-year low, the Carry Trade Index forged a 7.6 percent rally to pull back into range of 21,000. Supporting the rebound in price action, we have further seen market condition indicators report significant improvements of their own. The DailyFX Volatility Index edged 0.8 percentage points back to 19 percent and risk reversals are at their highest levels in nearly four-months.

While the market has shown a notable improvement behind sentiment, fundamentals suggest such shifts are counter-trend and therefore may be short-lived. Growth data is the most burning contradiction to a rebound in risk trends. Over the past few weeks, the US and UK both released advanced, 4Q GDP readings that put their respective economies in their worst recessions over two decades. More importantly, the trend in these broad growth readings and more timely, supplementary indicators imply these leading industrialized economies are heading for even worse going forward. Another aspect of the market that could quickly halt a rebound in confidence is the still-fading access to credit and lending. This past week, the Federal Reserve announced that it would defer the start of its $200 billion TALF program aimed at opening up credit lines to consumers and small businesses – the disconnect for many government bailout efforts to this point. At the same time, there are more than a few developments that threaten to destabilize the past few months of stability and revive panic. Among the notable headlines: Moody’s has said that it would review the rating on some $303 billion in commercial mortgage-backed securities; Standard & Poor’s expects dividends among the S&P 500 to drop the most since 1942 this year; and major, industrialized economies (among them Greece, Italy, Portugal and Russia) have seen their sovereign credit rating reduced. To find the momentum for a genuine rebound in risk appetite there market needs a break in the pessimism that supports a recovery in growth, lending and potential yields. Optimists suspect the US stimulus plan may do just that; but doubt is unrelenting.

 

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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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