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Has the Forex Carry Trade Topped?

Has the Forex Carry Trade Topped?

2011-05-18 13:53:00
John Kicklighter, Chief Currency Strategist

Carry Trade and Risk Report

By John Kicklighter, Currency StrategistforDailyFX.com

Published: May 18, 2011

Carry_Trade_and_Risk_Report_05.18.2011_body_x0000_i1025.png, Has the Forex Carry Trade Topped?Carry_Trade_and_Risk_Report_05.18.2011_body_x0000_i1026.png, Has the Forex Carry Trade Topped?
  • Carry Trade Slows its Dramatic Reversal as the Markets Watch Greece, US Debt, S&P 500
  • Risks Continue to Balloon for Gobal Financial Markets but Investors Choose to Ignore
  • Is the US QE2 Program Expiration the Key to Breaking Stubborn Risk Appetite Trends?

Just a few weeks ago, the capital markets, carry trade interest and investor sentiment itself were collapsing under their own weight. However, the tumble that began so dramatically seems to have run out of steam just as quickly. This has led many to label this pullback a mere correction and subsequently a ‘cheap’ level for buying back into risk. However, we should be skeptical of diving back in on a modest correction in an otherwise mature trend. The fundamental burden to secure meaningful gains from current levels is still exceptional; and therefore the potential for returns on long risk positions (equities, commodities, bond yields, carry) is naturally capped and expensive.

Taking stock of the price developments that we have seen in just the past few weeksacross capital markets, it is easy to see why undiscerning speculators would be drawn back into the long-only game. The S&P 500 represents the best positioned of the equity market benchmarks, having only corrected modestly from the multi-year high set at the beginning of the month – and only a month-and-a-half after the financial turmoil sparked by the Japanese earthquake. In commodities, we have seen US oil curb a deeper reversal by holding out at $95.00 while gold has refrained from dropping falling too far below $1,500. Perhaps the most appetizing draw for the global markets though are rates. The favored market for measuring funding costs – US Treasury yields have dropped to their lowest levels in six months. In contrast, tempered fear leverages the appeal of the least stable assets – the periphery EU debt. Two-year Greek government bonds yield 25 percent; while the Portuguese and Irish equivalents are at 12 and 10.5 percent respectively. This particular group offers a perfect reflection of the current balance of risk appetite / risk aversion in the market. The incredible rates on these assets are lucrative; but they are high for a reason – the exceptional risk that they compensate for.

Momentum and consolidation are reflections of speculative bias as much as they are an objective mirror of fundamental conditions. That is a key reason for trends lasting longer than we would otherwise expect or explaining why price action seems to ignore developments that would normally find big reactions from the market. The global impact of the Japanese earthquake in mid-March has come and gone. Initially, there were fears that the fallout from this natural disaster would take the region’s largest liquidity center offline; but Tokyo volume was only minimally effected – hence the quick recovery. In this current market correction, the issue is once again the European periphery. With the ECB backing off its interest rate pace; the market was once again focusing on the uncertainty surrounding Greece’s ability to weather its financial troubles and the fallout for its Greek and Irish counterparts. Yet, the market is already very familiar with the issues surrounding this particular group; and the likelihood of the contingent allowing Greece to withdrawal from the euro is exceptionally low. For now, officials are still buying time by promising solutions to complex issues (providing additional aid to Greece while avoiding a restructuring and not having to extend support to the Portugal and Greece at the same time). Eventually, that effort will hit a wall; but betting on the exact timing of that inevitability can prove costly.

In the meantime, there is a more clearly defined and perhaps even more influential concern that global financial markets will have to take more seriously approaching – the expiration of the US QE2 program. The $600 billion in stimulus the Fed will have pumped into the system through the middle of next month has bolstered confidence that the government would not allow a serious market correction while simultaneously fueling the carry trade that has guided capital to the high yield (and otherwise unstable) markets of the emerging market. What happens when that support is curbed and then eventually withdrawn? This is a question that speculators will begin to ask well before this evolution actually takes place. That said, we still have a number of weeks before actual steps are taken to shift the liquidity seas; so expectations for major trends in risk appetite and carry should be withheld until a definitive catalyst presents itself.

DailyFX Carry Trade Index

Carry Trade interest is plummeting from near, three-year highs in the most dramatic unwinding since the fallout from Japanese crisis in March.

Carry_Trade_and_Risk_Report_05.18.2011_body_Picture_22.png, Has the Forex Carry Trade Topped?

Risk Indicators:


DailyFX Volatility Index

Carry_Trade_and_Risk_Report_05.18.2011_body_Picture_25.png, Has the Forex Carry Trade Topped?

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_Trade_and_Risk_Report_05.18.2011_body_Picture_28.png, Has the Forex Carry Trade Topped?

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_Trade_and_Risk_Report_05.18.2011_body_Picture_31.png, Has the Forex Carry Trade Topped?

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_Trade_and_Risk_Report_05.18.2011_body_Picture_3.png, Has the Forex Carry Trade Topped?

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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