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S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

2011-10-29 04:07:00
John Kicklighter, Chief Currency Strategist
SP_500_and_AUDUSD_On_Pace_for_their_Best_Month_on_Recent_Record_body_Picture_5.png, S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

There was a remarkable surge in underlying investor sentiment and the capital markets this past week. In fact, this is merely the punctuation mark on a strong performance through the entire month of October. However, this surge (the best performance from the benchmark S&P 500 in over four decades and a post-float record for the yield intensive AUDUSD) flies in the face of heavy fundamentals winds. At the very foundation of the market’s performance, we are dealing with risk versus reward. There have been a few steps taken towards relieving immediate threats to financial stability; but they are far from a permanent foundation for confidence. And, drawing less attention is the return side of this balance. Reward is founded in economic growth, market expansion and rising yields. None of these components are currently improving.

Perhaps the key to the most recent thrust in the speculative recovery of the capital markets was the progress made on the European Union’s latest attempt at stabilizing confidence in the region’s financial health. In the true form of a collective looking for quick returns rather than long-term capital placement, we have seen the Euro, high-yielding currencies and global equities climb on the ‘success’ of the sweeping effort. However, we note that credit default swaps on sovereign and regional banks are still dangerously high, spreads for interbank funding are still exceptionally wide and Italian government bond yield are still climbing towards the critical 7 percent threshold. This offers a view beyond the limited engagement in buying depressed assets through a lull. With the medium- and long-term view that there is a severe lack of detail and will behind the Greek haircut, bank recapitalization and EFSF leveraging; the market still recognizes Europe as a significant risk to stability.

There is little doubt that Euro-area troubles will continue to boil beneath the surface; but in the interim, officials have bought a little more time and the market will therefore move on to more pertinent catalysts. When we are looking at trends behind risk appetite and carry trade interest; a genuine trend must come from a pervasive drivers. It is difficult to spot catalysts that would undermine global security ahead of time; but we do know that there are other concerns lingering in the background. Easier to distinguish ahead of time are events that can improve sentiment. Perhaps the most perceptible sparks on this front are the three monetary policy decisions scheduled for next week from the Federal Reserve, European Central Bank and Reserve Bank of Australia.

With troubled financial markets and stalled growth trends, an effort to ease monetary policy is the most sensible approach for officials. That is the lean that these three are expected to offer. The Fed will not likely increase its stimulus program; but the reflection on Operation Twist and Bernanke’s forecasts can open the door to further aid should it be needed. There is an off-chance of an ECB rate cut; but even in its absence, the market will be looking for some level of relief (nor or in the future) for a troubled Europe. Without doubt, the most volatility-laden decision will be the RBA’s announcement which is expected to deliver the long-awaited cut for the G7’s highest yield. This general shift towards support reduces risk; but we should remember it also lowers the ‘reward’ side of the equation as well.

DailyFX Carry Trade Index

SP_500_and_AUDUSD_On_Pace_for_their_Best_Month_on_Recent_Record_body_Picture_6.png, S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

Risk Indicators:

DailyFX Volatility Index

SP_500_and_AUDUSD_On_Pace_for_their_Best_Month_on_Recent_Record_body_Picture_27.png, S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

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

SP_500_and_AUDUSD_On_Pace_for_their_Best_Month_on_Recent_Record_body_Picture_30.png, S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

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

SP_500_and_AUDUSD_On_Pace_for_their_Best_Month_on_Recent_Record_body_Picture_33.png, S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

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:

SP_500_and_AUDUSD_On_Pace_for_their_Best_Month_on_Recent_Record_body_Picture_3.png, S&P 500 and AUDUSD On Pace for their Best Month on Recent Record

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 contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

To be added to John’s email distribution list, send an email with the subject line “Distribution List” to jkicklighter@dailyfx.com.

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