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A Steady Deterioration in Confidence Finally Finds a Catalyst for Panic Selling

A Steady Deterioration in Confidence Finally Finds a Catalyst for Panic Selling

2010-05-06 21:20:00
John Kicklighter, Chief Currency Strategist
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• A Steady Deterioration in Confidence Finally Finds a Catalyst for Panic Selling
• Dollar and Yen Rally as Carry Unwinding Leads Market-Wide Deleveraging
• Despite a 110 Billion Euro Bailout Agreement from the EU, European Crisis Leads Global Fears

It was a record-breaking day for the world’s financial markets. Spanning equities, currencies, commodities and fixed income, the consistent undermining of speculative confidence would finally meet a point where liquidity bottle-necked and general fear would lead to a perfect storm of rapid-fire deleveraging. There is no shortage of rumors over the cause of the worst tumble in speculative interest in decades; but catalyst and reaction are two different things. Even if the theory that there was a trading size error at one of the major banks (allegedly Citigroup issued a block sale on billions of Proctor & Gamble shares rather than the millions intended) holds water; an outsized sale of a single company’s stock should not have such a severe effect outside of the sector and perhaps a major index. Yet, the outcome was historic. For scope, the benchmark Dow Jones Industrial Average plunged over 990 points through Thursday’s session for the biggest intraday decline since the 1987 stock market crash. In other markets, crude would trade under $75 per barrel and gold reported its biggest daily gain (2.7 percent) since March of last year. The currency market was arguably the most volatile of the asset classes. Already on pace to unwind risky positioning, both the deeply liquid and naturally shallow pairs would suffer extraordinary volatility. For color on the FX market, USDJPY slid as much as 569 points while the more carry-specific AUDJPY collapsed 813 points. The prevalence and severity of this unique event suggest that regardless of the spark, the fuel for the rapid depreciation of ‘high-yield’ assets had already been spilled. Therefore, this magnitude of selling was inevitable – just not this quickly.

 

While today’s volatility was extraordinary, investor sentiment has been deteriorating for weeks. Market value has well-outpaced fair value since the speculators took over responsibility of the capital market’s climb back in the 2009 run. Yet in more recent months, the fundamental evidence that financial fissures are starting to turn into major chasms has grown to be overwhelming. Not long ago, the top concern on bears’ lists was the probability that China’s efforts to curb the growth in its economy and markets would undermine speculative confidence when few other sources of strength otherwise existed. With time, the focus on the world’s fastest growing economy would transfer over to the record amount of outstanding global debt that threatened sovereign credit ratings from economy’s as fragile as Iceland to those as robust as the United States. This spotlight on deficits would naturally bring media and ratings agencies to the worst of the offenders. While public debt in Japan may be 190 percent of GDP, it is Greece that has become the center of fears. With a shortfall of 13.6 percent of GDP, the nation finds itself stuck between severe spending cuts with recessions or a withdrawal from the European Union. Either way, conditions in the Euro Zone (one of the largest regional economies in the world) will suffer for confidence and investment. Since Greece first started to make the headlines, the country has asked for a bailout and has been assigned 110 billion euros worth of aid. However, the trouble has evolved to rapidly; and the fear of spread to Portugal, Spain, Italy, Ireland and the UK seem now inevitable. All that was needed to truly turn concern into panic was a unique selling event. With the market tumbling, market mechanics would kick in; and sell orders would overwhelm the market with a complete evaporation in liquidity. The natural outcome of this wave was gaps and historic lows – fear-inducing events in their own right.

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


DailyFX Carry Trade Index

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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 vice 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 pair's 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.

 

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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