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What do You Buy When the Dow Drops 400 Points - The US Dollar

What do You Buy When the Dow Drops 400 Points - The US Dollar

2011-09-23 04:14:00
John Kicklighter, Chief Currency Strategist
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What_do_You_Buy_When_the_Dow_Drops_400_Points_The_US_Dollar_body_Picture_5.png, What do You Buy When the Dow Drops 400 Points - The US Dollar
  • What do You Buy When the Dow Drops 400 Points - The US Dollar
  • Liquidity Troubles Unmistakable, Policy Officials May be Forced to Act
  • An Economic Slow Down, Financial Troubles, Drop in Rates – Down Goes Carry

Technically speaking, global equities have made the transition to a bear market. In most trading circles, this milestone is reached when a market drops 20 percent from its proximate phase high. And, what makes this far more disturbing than just a landmark is that with the backed up fundamental troubles behind the speculatively elevated market, there is very likely a deeper and more painful decline ahead of us. If we were to simply refer to the economic backdrop along with the standing risk/reward balance; the unwinding of risky positions would certainly continue. Yet, we need to be more wary of the speculative aspect of this equation as that will define the short-term volatility and momentum behind the market-wide swings from greed to fear.

If there was any need to confirm that we are looking at a genuine reversal in market-wide sentiment and positioning; there are plenty of signs for us to read. For the global macro trader; the correlation between the various asset classes – with the aggressive drive represented through all – is itself strong evidence. The column of assets that will collapse in this negative shift will be those that depend on quiet markets (low risk) to make relatively mediocre yield (reward). Naturally, the high-yielding currencies fit squarely in this group as the global level for benchmark rates is historically very low (while measures of risk, or the threat of volatile markets, is comparable to what we saw back in 2008 when rates were coming down from much higher levels). This reversal in borrowing from countries with near-zero rates and investing it those with pedestrian levels of return in turn drives capital back to its source. This is why the Japanese yen (with all its underlying financial issues, economic pain and warnings of intervention) can maintain its strength over other safe havens.

A natural correction in markets could unwind carry. However, the level of panic we have seen suggests something much more intense. The plunge in the S&P 500 and Dow Jones Industrial Average just over these past two days (6.0 and 5.9 percent respectively) alongside the biggest two-day rally from the benchmark 10-year Treasury note yield (to its lowest level on record) gives us a sense of just how heavy the capital flows are behind the shift. This fear no doubt can be partially traced to memories of what happened back in 2008. While we are not yet seeing the level of collapse that was driving the markets lower back at the height of the crisis; we certainly have the necessary pieces in place. China (as the poster child of the emerging markets) is standing on a potential sea of bad loans; the United States is facing the Fed’s cap on stimulus alongside the makings of a second round housing collapse; and Europe is actively struggling with a sovereign and banking financial crisis.

The next level of deterioration in this scenario is a complete freeze on liquidity. We have already seen the symptoms of such a scenario. Euro-area liquidity (using the three-month Libor and overnight index spread as our gauge) has dropped to lows last seen at the tail end of the Great Recession / Global Financial Crisis (March 2009). We have also seen the Euro – US dollar swap lines start to pinch as well. This suggests the worst of the problems are still harbored in Europe; but this situation is already spreading. What is the best candidate when capital markets are falling apart and liquidity is absolutely essential: the US Dollar.

DailyFX Carry Trade Index

What_do_You_Buy_When_the_Dow_Drops_400_Points_The_US_Dollar_body_Picture_6.png, What do You Buy When the Dow Drops 400 Points - The US Dollar

Risk Indicators:

DailyFX Volatility Index

What_do_You_Buy_When_the_Dow_Drops_400_Points_The_US_Dollar_body_Picture_16.png, What do You Buy When the Dow Drops 400 Points - The US Dollar

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

What_do_You_Buy_When_the_Dow_Drops_400_Points_The_US_Dollar_body_Picture_19.png, What do You Buy When the Dow Drops 400 Points - The US Dollar

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

What_do_You_Buy_When_the_Dow_Drops_400_Points_The_US_Dollar_body_Picture_22.png, What do You Buy When the Dow Drops 400 Points - The US Dollar

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:

What_do_You_Buy_When_the_Dow_Drops_400_Points_The_US_Dollar_body_Picture_13.png, What do You Buy When the Dow Drops 400 Points - The US Dollar

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, Senior 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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