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Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

2011-02-12 03:05:00
John Kicklighter, Chief Currency Strategist
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Currency_Markets_Risk_Appetite_Threaten_Trend_Defining_Reversal_Next_Week_body_Picture_8.png, Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week
  • Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week
  • Will the Economic Docket Claim Responsibility for the Next Trend or Pure Sentiment?
  • European Financial Strains and Chinese Bubble Concerns Starting to Show Through Equity Climb

The currency market - and perhaps the financial market at large – is looking at the best opportunity to jump start a meaningful and enduring trend that we have seen in many months next week. The vast majority of the time, the markets are set within some form of trend. This does not necessarily entail a bullish or bearish bias. Rather, the inclination resides in a sense of familiarity for the crowd. Whether the masses agree congestion on EURUSD, a persistent climb for the S&P 500 or tumble for the 10-year US Treasury note is the appropriate level of activity and direction; it is the consistency in performance that reinforces the trend and lulls market participants into a sense of comfort. Yet, it is inevitable that the speculative arena eventually changes gears. Identifying these moments early is not easy. A technical correction for a particularly liquid asset or even a concerted move across an entire asset class does not necessarily confirm an underlying shift. That is something we learned with the failed S&P 500 breakdown on last Friday of January and the short-lived reversal from AUDUSD back in November. A true trend change develops through an adjustment to fundamental expectations for risk and reward rather than a mere shock of volatility. And, these are the exact elements that we are looking for the immediate future.

We have been looking for evidence of an obvious revival in correlation across the various asset classes and subsequent drive behind this freshly connected market for some time. Aside from a few brief periods of heavy risk-driven moves; we haven’t seen anything this consistent since the reinvestment effort after the worst of the financial crisis between March and December of 2009. Leading up to the ultimate return of conviction, we find complacency and under-appreciation of risk have become the rule. We see a lack of concern in the equities-based VIX Index just off three-and-a-half year lows while junk bond spreads have contracted to levels last seen in 2007. What makes this complacency dangerous is the steady advance in speculative assets. The balance of expectations for reasonable returns against the threat of financial instability has been heavily skewed such that the market in general finds itself richly valued. However, investors can remain ignorant of this threat and continue to plow money into the markets until something forces the masses to reevaluate the situation. What we need is a catalyst or range of catalysts to shake confidence.

Taking stock of the danger of a collapse in confidence through the immediate future, we only need to look at the economic calendar. We will be reminded of Europe’s long recovery time with the release of the region’s first round of 4Q GDP figures. This includes not only the Euro Zone and Germany figures but the Portuguese and Greek updates as well. This could easily swamp the inert recovery in confidence the region has found due to the open-ended and so far shaky promise policy officials made to expand their bailout efforts. In the UK, the front-line battle between fiscal austerity, economic growth and high inflation will be strained by employment data and the BoE’s Quarterly Inflation Report. Largely overlooked, the US started the wheels turning on transferring the glut of toxic assets off the government’s balance sheet back to the blissfully ignorant speculator by announcing its intensions to wind down Fannie Mae and Freddie Mac. Then, there is China’s accelerating effort to tighten the reins on speculative capital. This gives rise to the potential momentum behind the inevitable risk aversion move. Global investors won’t necessarily withdrawal funds from the system so much as they will correct the imbalance between developed and emerging market economies and reverse the steady speculative build up.

DailyFX Carry Trade Index

Currency_Markets_Risk_Appetite_Threaten_Trend_Defining_Reversal_Next_Week_body_Picture_3.png, Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

Risk Indicators:

DailyFX Volatility Index

Currency_Markets_Risk_Appetite_Threaten_Trend_Defining_Reversal_Next_Week_body_Picture_4.png, Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

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

Currency_Markets_Risk_Appetite_Threaten_Trend_Defining_Reversal_Next_Week_body_Picture_5.png, Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

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 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

Currency_Markets_Risk_Appetite_Threaten_Trend_Defining_Reversal_Next_Week_body_Picture_6.png, Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

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:

Currency_Markets_Risk_Appetite_Threaten_Trend_Defining_Reversal_Next_Week_body_Picture_7.png, Currency Markets, Risk Appetite Threaten Trend-Defining Reversal Next Week

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

To receive John’s reports via email or to submit Questions or Comments about an article; email jkicklighter@dailyfx.

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

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