Speculative Markets May Finally Watch Volatility with Direction when Liquidity, Fundamentals Return
• Speculative Markets May Finally Match Volatility with Direction when Liquidity, Fundamentals Return
• Does Spain’s Downgrade Offset China’s Vote of Confidence in the Euro? |
• Interest Rate Expectations Shift as Growth Forecasts Start to Dim in the Face of Financial Trouble
That capital markets are heading into the eye of what may prove to be a speculative hurricane. In the leading arm of the this disruptive market pattern, most asset classes were suffering from extraordinary levels of volatility; but true to the weather analogy, there was no clear direction to be made out of this chaos. The level of overall activity should not be surprising however given the pace the speculative crowd has kept over the past month. And, for this same reason, the level bearing on risk appetite should not come as a shock. After an aggressive and distinct trend, a period of stability and/or temporary retracement is to be expected. However, now we are passing through the eye of storm where conditions seem calm and almost normal. Aside from it being the weekend, the markets are further depressed by a marked drop in liquidity. On Monday May 31st, the US and UK exchanges and banks will be closed for holiday. Naturally, this absence of participation would be expected to drain potential breakouts of trend-establishing potential and keep the tendency for sideways price action that was established this past week in place. On the other hand, this downtime will not last for very long. On the turn of the month, the markets will fill out and fundamental activity will pick up significantly. When it is ‘business as usual,’ the masses will once again be tasked with establishing a clear direction on building or deleveraging exposure (put a different way: take a position for risk appetite or risk aversion). There is clear pressure for taking up a position when looking at the various markets. For equities, the back and forth around the psychologically-important 10,000 level for the Dow has temporarily incapacitated investors. In the currency market, the focus is on EURUSD. The world’s most liquid pair (and tradable vehicle) is stationed just above the mid-point of its historical range. Either the 1.2125 level will have give way to fear or support a rebound as optimism returns.
When liquidity returns this coming Tuesday, there will be plenty of potential catalysts to absorb. By far the greatest concern is the lingering fear that another global financial crisis could spread from the European Union. Over the past few weeks, the news headlines have died down and the erratic and panicked surge in government financing costs for the regional economies has eased. This suggests speculative interest is waning until the next spark erodes confidence that the region’s policy makers will be able to avert a financial disaster and secure one of the world’s largest economies. Late-session news that Spain’s sovereign credit rating was downgraded by Fitch Friday adds to the mix; but the lack of liquidity was a fortunate buffer. Moving forward, though, the impact this will have on future and necessary debt auctions will be palpable. Monitoring the constant effort to raise capital, attempt to cut spending programs, and the economic and social impact all of this has will be essential to gauging the true significance of the situation. However, the markets are more prone to panic and euphoria; so big headlines may offer the most dramatic impact. On this front, the G20 meeting that will begin late in the week could leave us with a global effort to help the EU; or expose another missed attempt at coordination (just like was seen before the 2007-2008 financial crisis really hit its stride). How about for the long term, are the euro and the Monetary Union that backs it secure? China threw in its confidence and said its allocated funds would remain in European assets. On the other hand, the structural issues that have long undermined the uniform application of fiscal responsibility and economic stability cannot be solved by outside investment or a local bailout program. Looking beyond the EU quandary, there are more than a few indicators that could spur yield demand or risk aversion. US NFPs is perhaps at the top of the list given its 500,000 increase forecast. Yet, RBA and BoC rate decisions, Canadian and Australian GDP figures, European money growth and employment; and UK public debt all hold potential.
|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.
|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.
|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.
Is Carry Trade and risk appetite rising or falling? Discuss how to trade yields and market sentiment in the DailyFX Forum
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 email@example.com.
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.