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Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End

Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End

2011-05-27 05:00:00
John Kicklighter, Chief Currency Strategist
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Carry_Trade_Consolidates_Alongside_EURUSD_and_SP_500_body_Picture_8.png, Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End
  • Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End
  • Continuously Tumbling US Rates Further Leverages the High Return Side of FX Trading
  • Will the European Financial Sovereign Debt Crisis Spark a Global Risk Aversion Move?

Risk appetite and carry trade move hand-in-hand. Considering the popular FX strategy is heavily influenced by the level of yield the currency market is offering to offset perceived global risks; carry itself is a true reflection of the balance between potential for return and loss. For investor confidence this past week, the market made a concerted effort at consolidating its recent losses. The bearish turn in capital markets and yield-intensive assets from the beginning of May has been a restrained one for the most part; and the progress on the reversal has therefore so far been restrained. For market progress, the DailyFX Carry Trade Index has risen modestly from the same period last week; while the benchmark S&P 500 has similarly bounced from a one-month low.

The general lack of progress (bullish or bearish) on risk appetite trends can be traced back to the lack of fundamental conviction one way or the other. Remarkable threats to market stability have emerged in the past few weeks; but their influence has yet to prove contagious. The most prevalent concern is the European Union’s sovereign debt troubles. Instead of speculation through financial media that Greece is considering a withdrawal from the shared currency and the common monetary policy it fronts; we have EU Official Juncker voicing concern that the country will not be able to meet the IMF’s requirements to draw its next round of financial support. Such an outcome would essentially be tantamount to a restructuring or some similar dramatic change in efforts as such a move would put repayment even further beyond the capacity of the troubled nation. The euro’s troubles happen to be the most pressing; but there are many other issues that could quickly turn the market to panic – though they happen to be further from catalyzing. The Bank of Japan is considering further expansion of its monetary policy effort as concerns that the financial fallout from the March quake were more severe than expected. The shining example of fiscal austerity, the UK, is starting to show the economic impact of taking the hard path toward stringent policy. Skepticism surrounding China’s booming economy – fed by excessive lending – is starting to reach the mainstream. And, perhaps the most tangible threat is the impending expiration of the Fed’s accommodative monetary policy stance.

Investor confidence translates into economic growth, credit flow and normally functioning markets. When market participants are reasonably certain that they will be able to recover their initial capital and decent return; they are willing to lend the capital. However, the balance of expected return against prevailing risk is a critical factor in how fluid this aspect functions. That said, there is a lot of confidence that has been built into the market through explicit (such as bank bond guarantees) and implicit (and lending facilities) stimulus. This government-derived support has been labeled by some ‘moral hazard’ for good reason. When this temporary support is withdrawn, investor confidence could retreat along with it. Yet, this stimulus will not be withdrawn altogether. It will level off for a period; and that has led to an unusual situation: whereby US short-term lending rates (Treasuries and Libor) have dropped to multi-month and even record lows. That inherently lowers the cost of the carry trade as it reduces the rate on the funding currency and increases the differential with high-yielding alternatives. The resulting higher return works to offset the growing risks (which have yet to fully mature); and savvy investors jump on the opportunity. The music won’t last for much longer; but while it does, the returns are enticing.

DailyFX Carry Trade Index

Carry_Trade_Consolidates_Alongside_EURUSD_and_SP_500_body_Picture_3.png, Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End

Risk Indicators:

DailyFX Volatility Index

Carry_Trade_Consolidates_Alongside_EURUSD_and_SP_500_body_Picture_27.png, Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End

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_Consolidates_Alongside_EURUSD_and_SP_500_body_Picture_30.png, Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End

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_Consolidates_Alongside_EURUSD_and_SP_500_body_Picture_33.png, Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End

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_Consolidates_Alongside_EURUSD_and_SP_500_body_Picture_6.png, Carry Trade Consolidates Alongside EURUSD and S&P 500 as Market Awaits QE2 End

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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