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Equities, Commodities and Currency Markets Concede to Risk Aversion and Deleveraging

Equities, Commodities and Currency Markets Concede to Risk Aversion and Deleveraging

2010-05-20 23:45:00
John Kicklighter, Chief Currency Strategist
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• Equities, Commodities and Currency Markets Concede to Risk Aversion and Deleveraging
• A European Union Crisis is Still the Primary Global Threat, Though the Trend May Now be Self-Sustaining
• Implied Volatility Quickly Rising Towards Post-Lehman Highs as Interest Rate Expectations Reverse

Like the markets themselves, investor sentiment is prone to establishing trends. Throughout 2009, optimism and complacency were in full swing as an influx of sidelined funds would lead to capital appreciation and in turn feed speculative opportunities. As momentum established itself, discouraging news and forecasts were generally disregarded as market participants were bent on recovering from losses sustained during the previous year’s crash. However, like any normal cycle, sentiment will eventually give out and risk aversion will define the dominant trend. We may already be at this point. Back on May 6th, a severe intraday decline in the benchmark US equity indexes alluded to an abrupt reversal in one of the most robust bullish trends in recent market history. Yet, the immediate threat was chocked up to errors in the system. Nonetheless, the effects this ‘aberration’ would have on other asset classes implied sentiment had in fact deteriorated and all that was needed was a noteworthy catalyst. To further confirm the unequivocal collapse in optimism, the failed attempt to recover from the single-day, nearly 1000-point plunge (for the Dow Jones Industrial Average) would soon lead to the next wave of deleveraging and risk divestment. This is the position we find the markets in this week. From the traditional asset classes, the Dow has suffered its worst decline (on the close) in 14 months and the benchmark 10-year Treasury note has been bid up to its highest level in a year. In the currency market, the evolution of risk was a little more complicated. The plunge in the euro and rally in the US dollar would usher in the transition well before the media would pick up on the shift. But, after six months of steady downtrend, EURUSD has already exercised a considerable portion of its excess premium. Does this mean that the FX market will no longer participate in the broader decline in sentiment? Certainly not. The high-yield commodity crosses are still close to bullish extremes in many instances and the dollar is still the primary safe haven in the market. All that is needed is conviction and perhaps catalysts.

When looking for the fundamental fuel behind the reversal in risk appetite, we may not need a particular driver to feed worry and thereby push yield-bearing assets lower. Having established a robust and consistent trend towards risk aversion through the fear of another global financial crisis arising from the European Union, momentum has already changed course. Without capital gains to feed speculation, investors are more conscious of the anemic yields that can be garnered from the liquid markets. However, fundamental doubt is a necessary element in sustaining the trend of risk aversion. Over the long-term, the outlook for measured economic growth and equally tepid interest rate expansion will dampen the craving overinvestment. Actually encouraging a further withdrawal of capital from the capital markets over this time frame is leverage. Not only are investors having to borrow funds to make measureable returns on capital movements; but governments themselves are highly exposed with junk assets that were taken off the hands of major financial institutions and through the record outlay of stimulus funds. Right now, sovereign credit risk is a prominent fear; but it is isolated to just few spots on the global map. Greece is the most recognizable threat with a quick descent into insolvency accelerated by a distrusting debt market. The European Union still poses a substantial threat to general stability; but the 750 billion euro rescue program that was agreed upon by the region and IMF will likely by officials time (though that does not mean the problem has been solved). In the meantime, fiscal troubles in the US and UK among others has grown in prominence. Perhaps the most worrisome future is attached to Japan that has debt nearly two times GDP and a history of financial malaise. And, if these concerns are still too obscure to the average investor; there is always the possibility that China’s speculative bubble is on the verge of bursting. 


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


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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