It is difficult for anyone to miss the massive wave of risk aversion that has washed over the global markets these past two weeks. With basic lending and borrowing (the lifeblood of the financial system) frozen by oppressively high rates, the markets are being held hostage by sentiment; and until pessimism eases, the risk-related assets will maintain their bearish trajectories.
• Worst Market Crash In Recent History Sends Risk Appetite And Carry Plummeting • DailyFX Carry Trade Index Near Five Year Low As Volatility Indicator Hits Recent Record High • Is This Irrational Exuberance And What Can Cure It?
It is difficult for anyone to miss the massive wave of risk aversion that has washed over the global markets these past two weeks. With basic lending and borrowing (the lifeblood of the financial system) frozen by oppressively high rates, the markets are being held hostage by sentiment; and until pessimism eases, the risk-related assets will maintain their bearish trajectories. For the currency market, the best measure for fear is the carry trade. Today, the DailyFX Carry Index dropped to 22,444 – its lowest level in five since the final months of 2003. Far more concerning though is the accelerated rate of the decline. Since the peak back in the summer of last year, the basket has dropped 30 percent; but in just the past week, it has dropped 12 percent. Such an aggressive drop is pure panic, and other market condition indicators confirm the environment. Risk reversals have shown a dramatic increase in put premiums while the DailyFX Volatility Index has ballooned to an unheard of 18.7 percent. These conditions can’t last forever, but they can get worse.
While forecasts for a global recession is a significant burden on the appetite for risk, the true root of this market panic is credit. Since the rebound in investment trends after the Dot-Com bubble, businesses, consumers and investors leveraged themselves through credit. After the long build up, the house of cards first started to collapse with the sub-prime mortgage market. Mortgage rate adjustments led to defaults which then exposed the massive leverage built up in credit derivatives. What’s happening now is the rapid unwinding of this built up leverage. This is an essential step to putting the global markets and economy back on an even keel; but the fear that has accompanied the move has concentrated the pain rather than allowing conditions to deflate in an orderly economic down turn. Ongoing efforts by policy officials to stem the bleeding have done next to nothing to stop the tide. The coordinated rate cut earlier this week has (not surprisingly) failed to encourage investment when banks are struggling to move depressed assets off their books. Both the US and UK bailout plans are promising as longer-term fixes, but they are weeks away from actually drawing the bad debt from the markets. Looking ahead, this weekend’s G7 meeting may see additional rate cuts; but the Fed’s planned CDS clearinghouse holds true potential.
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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.