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Fresh Yearly Highs for the Markets Belie Shaky Confidence, Persistent Uncertainty

Fresh Yearly Highs for the Markets Belie Shaky Confidence, Persistent Uncertainty

2010-03-19 03:47:00
John Kicklighter, Chief Currency Strategist
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• Fresh Yearly Highs for the Markets Belie Shaky Confidence, Persistent Uncertainty
• Greece Concerns Refreshed by Country’s Own Time Line for the EU
• Where Simple Appreciation in Markets No Longer Accounts for Speculative Conviction

All the standard proxies for risk appetite and risk aversion seem to be pointing to a steady advance in investor sentiment and the evolution of a true bull market. However, behind the bearings of speculative market benchmarks lies concerning discrepancies. From a fundamental standpoint, the threat to stability is obvious. Ranging from well-worn threats like the European Union moving towards a Greek-born crisis to comparatively new dangers like a possible sovereign credit downgrade for the United States and United Kingdom, risk is a global phenomenon. Yet, market participants have successfully navigated around such obvious perils in the past to bolster their confidence levels. As evidence to that fact, we only need to look at the many indexes and activity indicators that have extended their trek into positive territory. The most remarkable climb has come on the equities side. Lagging many of its counterparts, the Dow Jones Industrial Average managed to surpass its previously held 17-month high with one of the most consistent bullish leg seen since the initial reversal and recovery effort made one year ago. From there, the standard bearers for risk – the volatility indexes – have tumbled to lows not seen in years. In fact, the CBOE’s VIX holds just above lows last seen before the market began its tumble back in the summer of 2007. On the other hand, we can already see the irregularities in these foreground readings. Despite the consistency in the Dow, there is an inexplicable lack of momentum and volatility that is often associated with breeching a psychological level of resistance. Looking to other capital markets, there is a clear hesitancy amongst commodities and bonds to forge their own remarkable developments. In the end, though, the dollar is perhaps the best barometer. The safe haven and influx funding currency has maintained congestion for going on a month and a half now.

It is not unusual for fundamental reality and speculative ideal to part ways for extended periods. This is just the nature of fear and greed. However, it is an inevitability that investor expectations and market valuations will have to once again converge. It is theoretically possible for economic activity and potential returns to advance enough to meet buoyant projections from an optimistic crowd; but the likelihood of speculative interests holding up long enough for stagnant growth to catch up to such optimistic evaluations is highly improbable. In the meantime, there are many looming global threats to shake the market from its complacency. The most readily accessible circuit breaker for bulls is the situation in the European area. Though the market has seem to let up on its fears of an impending default for Greece; the outlook for the economy and region have not improved significantly over the time. The Greek Prime Minister has recognized the situation has progressed little; and realizing the nation would soon need to rollover debt at still inflated lending rates, he has laid out a deadline for the EU to produce a viable rescue plan should it be needed. To this point, the group has agreed on little beyond voicing confidence and praise in the nation’s efforts to cut its deficit; but the markets will need more than mere jawboning to reinforce confidence in their positioning. And, while Greece is perhaps one of the most accessible land mine to financial security, there is plenty of risk to highlight. Somewhat overlooked; but highly incendiary is the warning by Moody’s that the UK and US, among others, have moved closer to losing their top credit rating. A downgrade to one of these primary markets would be devastating; but the same for a smaller nation could easily ripple across the globe. Finally, in the background, there is always the threat of an asset bubble in China. A bursting of this bubble would be severe; but deflating could easily sabotage fragile sentiment.

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:
carrytrade_0318-3 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.

carrytrade_0318-4 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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