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Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?

Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?

2010-07-23 23:36:00
John Kicklighter, Chief Currency Strategist
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CarryTradeBasket723_body_x0000_i1025.png, Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?CarryTradeBasket723_body_x0000_i1026.png, Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?
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The Committee of European Banking Supervisors released the results of its region-wide stress test on 91 European banks that account for approximately 65 percent of the systems total assets. If we were to go by market reaction alone, it would seem that confidence has prevailed and the results offer a promising future that could alleviate much of the uncertainty that has plagued the markets over the past few months. However, the reaction to this collective event was stunted by liquidity, ambiguity and hesitation. Come Monday, investors may produce a very different response to this ‘positive’ release – a reaction that could very well lead to the next, clear phase of sentiment for the capital markets. The first reason to doubt the markets reserved reaction to today’s event risk is the timing. Strategically released after the close of the European session, only Foreign Exchange traders and US-based market participants were capable of reacting to the results. However, considering this group only accounts for a fraction of the total market; the possibility of a sharp reversal when the markets fill out next week is too much of a risk for short-term speculators and long-term investors alike. As tactical as the release time was, the advantage of extra time to interpret the results may not improve confidence.

By far the greatest flaw to the Stress Test results was the methodology for which the conclusions were calculated. Of the three scenarios that were used to assess the banks’ ability to withstand a slump in the markets and growth, the worst was labeled the “sovereign shock” state. Though it would seem that the situation in this scenario would be a sovereign default, it is in fact based upon private failures that result from a further downturn in the economy. A 20 percent drop in equities, four-step downgrade in the ratings of securitized derivative products and cumulative losses in five year government debt (equaling 23 percent for Greek bonds, 14 percent for Portuguese, 12.3 percent for Spanish and 4.7 percent for German) may seem remarkable; but a default by any one of these governments (or a periphery European economy) could spark a financial crisis that quickly surpasses this damage tally. It is further interesting that the seven banks that reportedly failed the stress tests are tied to government funds. The German government controls Hypo Real Estate, the Greek government owns 77 percent of the Agricultural Bank of Greece and there is a rescue fund that the 5 Spanish cajas that failed can access after the sectors’ consolidation is finally complete. Suggestions by certain officials that this evaluation was very strict or was more stringent than the test the US ran a year ago is disingenuous. The consistency and transparency in the US evaluation was believable because the government required those institutions that fell short to borrow money to meet the requirements. And, a problem that exists in all of these tests is the reality that the smaller banks are the ones most likely to collapse.

Going forward, the reliability of the CEBS’s evaluation will be questioned and pressured by the market itself. However, the greatest threat to financial stability and risk appetite is an unquestionable event that supersedes the tests. A default by Greece would be the most publically destructive situation; but that would take time to develop and aid could cloud the reaction. More feasible is the deterioration of a banking system in one of the member economies. Many financial institutions (like those in Spain) have been cut off from the market by exorbitant yields and diminished foreign investment. Perhaps the most imminent threat to Europe though is a collapse in one of the periphery European nations. Standard & Poor’s warned today that it may downgrade Hungary’s sovereign rating to junk status after the EU and IMF broke off talks to extend another loan on the basis that the nation was not taking the necessary steps to rein in its deficit. All that is needed is a spark to ignite the volatile situation. And, lest we forget, Europe isn’t the only global threat. According to Bloomberg News, regional Chinese governments can only pay off 27 percent of their loans as of today.

CarryTradeBasket723_body_Picture_19.png, Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?

Risk Indicators:

Definitions:

DailyFX Volatility Index

CarryTradeBasket723_body_Picture_28.png, Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?

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.

USDJPY 25 Delta Risk Reversals 3 Month

CarryTradeBasket723_body_Picture_31.png, Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?

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.

Reserve Bank of Australia Expectations

CarryTradeBasket723_body_Picture_34.png, Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?

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.

Highest And Lowest Yields:

CarryTradeBasket723_body_Picture_3.png, Is the Mute Euro and S&P 500 Reaction to the EU Stress Test Results a Sign of Confidence?

The Interest rate used to benchmark the currency basket is the 3 months Libor rate

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.

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

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