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Price Action Points to a Bullish Breakout but Market Fundamentals May Force a Collapse

Price Action Points to a Bullish Breakout but Market Fundamentals May Force a Collapse

2010-03-15 16:16:00
John Kicklighter, Chief Currency Strategist
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• Price Action Points to a Bullish Breakout but Market Fundamentals May Force a Collapse
• Greece, China and Global Sovereign Credit Ratings are but a Few of the Threats to Stability
• The US Dollar Slips without Confirmation of Risk Appetite from Commodities or Equities

There is a growing divergence in the state of the financial market’s fundamentals and its general level of activity. In the past week, there have been developments that have degraded the fidelity of the Euro Zone, leveraged the threat of a financial crisis in China and added risk to the very assets that are used to establish risk-free returns. However, the benchmarks for speculative positioning have either held their ground or maintained a gradual advance in favor of growth and yield. How can this dichotomy exist and when will it rectify itself? Assessing the situation objectively, it is possible to quantify the complacency of the market. Looking at traditional volatility measures, the S&P 500’s VIX Index is hovering just off of its lowest level since May 2008 while the currency equivalent currently stands at an 18-month low. Another approach to appraising activity is through calculating the average daily range of different markets. This measure of price action shows the Dollar Index just nearing an August 2008 low, crude easing to levels of lethargy last seen in September of 2007 and the Dow Jones Industrial Average just off of an average daily range not witnessed since the beginning of 2007. For changes in value itself, both equities and crude have advanced at a steady clip while the benchmark currency has essentially made no progress in over a month. Which is the better reflection of sentiment? The currency market. The notable appreciation in stocks and commodities is undeniable; but this has taken place within the confines of a broad range. Both the Dow and crude have prominent swing highs that were set back in January; and neither has yet to contest their respective milestones in this climb. When conviction in trend is revived (be it bullish or bearish), the correlation between these markets will return and there will be little doubt as to the market’s intentions.

On the other hand, it is not difficult to mark the return of volatility. It is, however, difficult to establish the direction the risk appetite and positioning ultimately take with this resurgence. Over the past month, the evidence of a move towards speculative position building has been made abundantly clear through the appreciation of the commodity and financial instruments (stocks and bond yields). Yet, in contrast, the economic and speculative arguments to be made for assuming greater risk have deteriorated over the same period. The greatest concerns can be split into two categories: issues that are currently influencing the market’s normal functioning and those threats that have yet to mature. The headline for the former column is the uncertainty surrounding the Euro Zone. The clearing in market volatility itself seems to have prevented a crisis with Greece as risk premium demanded for the nation’s debt have deflated. However, this is a fragile calm that could easily be broken by a shift in the currents of investor sentiment. And, considering the wide skepticism over the possibility of a European Monetary Fund, the national strikes in Greece and the reality that it will take significant suffering for EU nations to return to respectable levels of growth and indebtedness; balanced investor sentiment is all the region has going for it. The list of potential threats is long and growing. In China, recognizing the trouble that property speculation and lending have raised for the economy, the government vowed regulation and nullified all loan guarantees made by local government. This second effort is particularly worrying because it opens the doors to a wave of defaults as activity does cool. Other pending issues include the rating agencies’ warnings to the UK about its banks’ credit ratings, government stimulus withdrawal and global sovereign debt ratings.

Is Carry Trade and risk appetite rising or falling? Discuss how to trade yields and market sentiment in the DailyFX Forum

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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 USDJPY as global interest are bottoming after having fallen substantially over the past year or more. Both the US and Japanese benchmark lending rates are near zero and expected to remain there until at least the middle of 2010. This attributes level of stability to this pairs options that better allows it to follow investment trends. When Risk Reversals move to a negative extreme, 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.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

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