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Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted Confidence

Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted Confidence

2011-02-19 02:45:00
John Kicklighter, Chief Currency Strategist
Share:
Carry_and_Risk_Appetite_Steady_Until_a_Definable_Event_Shakes_Unwarranted_Confidence_body_Picture_4.png, Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted Confidence
  • Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted Confidence
  • European Financial Troubles. Chinese Rate Hikes. Sentiment Grows Acclimated to Speculative Curbs
  • Interest Rate Expectations Riding on the Same Optimism that has Swept up Capital Markets

A haughty sense of risk appetite continues to push the speculative-driven capital markets to new highs – suggesting both that the outlook for returns continues to climb and any risk to market stability fades into background. If we were in a period of consistent and rapid global growth where the efficiency of capital were forcing investors to generate returns above and beyond the market’s already robust yield; this would seem a reasonable assessment. Yet, the fundamental backdrop paints a far more reserved outlook than what capital markets and their premiums would suggest. An unbalanced global economy, the inevitable withdrawal of cheap funds with stimulus unwinding, recurring financial crises in various corners of the world and other concerns present a greater and greater threat the more richly valued the financial assets become. Nevertheless, the climb continues. What is the source of this widening gap between positioning and fundamentals? Speculation. That said, a drive based on a collective exaggeration of expectations can be self-sustaining; but only for a finite time. Eventually, traders have to take profit when actual yields don’t compensate for exposure.

It is difficult to envision a challenging period for markets when so many benchmarks are scaling new highs and the backdrop for activity points to stability. Looking to the currency market, we see that the Carry Trade Index is holding just off of a remarkable push to highs last seen back in September of 2008 (before the worst of the US financial crisis). At the same time, the currency-based volatility index (using FX options and used to measure insurance premium for underlying positions) has dropped to its lowest level since August of the same year (10.39 percent). From other asset classes, we can see that the S&P 500 equity market benchmark has scaled two-and-a-half year highs at a remarkably consistent pace, UK-based Brent oil has surpassed $100/barrel for the first time in over two years and the 10-year Treasury yield is just off eight-month highs. When markets rise to such heights, securities carry their own gravity – drawing in capital from the late but hungry speculators. However, behind this drive, conviction is starting to wane while doubt spreads. In fact, this past week, the Yale School of Management released a survey of wealthy investors. In this study, 75 percent of respondents thought there was a 10 percent or greater probability of a “catastrophic” US stock market crash in the coming six months. This reading was higher back on March of 2009 – notably calling the bottom to the current rally – but the conditions between today and two years ago are vastly different. In the end, the threat of a crash isn’t necessary; a natural reconciliation to fundamentals would be major itself.

Looking ahead to the coming week, there aren’t any particular scheduled economic releases that threaten to shake the system. However, data like European GDP, UK consumer inflation data, the release of the FOMC minutes and others wouldn’t likely carry a meaningful shift in underlying sentiment. Critical rebalancing events carry the necessary weight to infect the entire market. In this there are plenty of cracks to highlight. We could point to spreading unrest in the Middle East, soaring commodity prices, China’s ongoing efforts to curb the “hot” capital inflow (which the estimated to be $35.5 billion in 2010) or any other number of ongoing developments; but the true destabilizing event will likely be something that hits directly at the speculative masses. A meaningful deterioration in European financial health (either the announcement of bondholder hair cuts or a ballooning of debt) or the inevitable unwinding of stimulus which increases the cost of leverage represent clear threats to speculation. Timing their influence is the difficult part.

DailyFX Carry Trade Index

Carry_and_Risk_Appetite_Steady_Until_a_Definable_Event_Shakes_Unwarranted_Confidence_body_Picture_5.png, Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted Confidence

Risk Indicators:

DailyFX Volatility Index

Carry_and_Risk_Appetite_Steady_Until_a_Definable_Event_Shakes_Unwarranted_Confidence_body_Picture_16.png, Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted 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

Carry_and_Risk_Appetite_Steady_Until_a_Definable_Event_Shakes_Unwarranted_Confidence_body_Picture_19.png, Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted 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 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 end of 2011. 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

Carry_and_Risk_Appetite_Steady_Until_a_Definable_Event_Shakes_Unwarranted_Confidence_body_Picture_22.png, Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted 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:

Carry_and_Risk_Appetite_Steady_Until_a_Definable_Event_Shakes_Unwarranted_Confidence_body_Picture_3.png, Carry and Risk Appetite Steady Until a Definable Event Shakes Unwarranted 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

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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