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Despite a Key Dollar Breakout and Steady Dow Advance, Risk Appetite Trends Have Yet to Recuperate

Despite a Key Dollar Breakout and Steady Dow Advance, Risk Appetite Trends Have Yet to Recuperate

2010-03-26 01:53:00
John Kicklighter, Chief Currency Strategist
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• Despite a Key Dollar Breakout and Steady Dow Advance, Risk Appetite Trends Have Yet to Recuperate
• EU Deliberates on a Greece Financial Aid Plan, but is Portugal’s Downgrade the Bigger Concern?
• Interest Rate Differentials Start to Narrow as Hawkish Forecasts Spread

A haphazard assessment of the broader financial markets can easily come to the conclusion that risk trends are once again in full swing. The steady move from the Dow Jones Industrial Average and a recent spike in volatility from the dollar would seem proof positive that activity is on the rise. However, with a closer look at the market, it becomes clear that these two remarkable developments are contradictory; and there is a remarkable lack of momentum behind both of them. With lingering financial dangers (like worrying how deep the rabbit hole goes for the European Union) along with tepid growth and yield expectations ahead us; there is reason to doubt the establishment of hearty trends. Yet that is exactly what we have come across when we look at the equities and to a less extent the commodities markets. The Dow has pushed consistently to fresh 18-month highs while crude oil is just off of similar highs. This buoyancy points to risk appetite as investors transfer their funds into markets that have far greater potential for capital returns that regular income at this point. Yet, on the other hand, the recent surge from the US dollar that quickly turned the currency from seven weeks of congestion to a new 10-month highs would seem to support a move towards risk aversion. As the market’s favored safe haven for the past few years, the greenback appreciation seems to directly conflict with the rise in equities. Rather than simply suggesting the market is giving us a mixed picture; this unusual development can be quite simply explained in that there is no clear trend in underlying investor sentiment. Ongoing congestion is merely allowing the transfer of capital to establish trends. For evidence, we need look no further than the carry trade itself. A pure balance of risk and reward, the strategy stalled six months ago.

Coming to the conclusion that risk appetite is simply directionless, it is important to understand why this may be the case. There was no doubt that the redistribution of sidelined capital and the draw of quick gains helped spur the market’s to impressive gains through 2009. However, this appreciation would eventually meet a fundamental ceiling – a level where the risk of uncertainty and a profit-erasing reversal balanced out against the hope for further returns. Having established a period of congestion, speculators will progressively lower their expectations for capital gains and unwind risky positions. When there is a modest level of income or yield added to the equation (as with debt and equities) it is possible to hold out longer. Nonetheless, the imbalance still exists; except, here, the arguments are more fundamentally rooted. With the more traditional asset classes, the steady influx of speculative capital along with government support is more influential. However, the ongoing advance from equities further increase the inequity between market price and fair value; and the ultimate correction will ultimately be more violent. Yet, with as much certainty as can be mustered in assessing an overvalued market, the market’s ability to run astray of fundamental trends can burden an effort to position for a resolution between theory and practice. Therefore, it is best to wait for confirmation of such a development. And, what can spur the market to such a end? There is no shortage of concerns. Warnings that the world’s largest economies were close to losing their top credit ratings, an impending UK election, speculation that China may hike its reserve ratio, Japan’s failing fight with deflation and the EU’s struggle to ensure financial stability are just those things that are currently in play. New concerns will no doubt pop up with time.

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_0325-3 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_0325-4 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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