Risk Appetite Stalls But the Dollar and Dow Maintain Trend Through Week's End

Published October 17th, 2009 - 03:05 GMT

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Risk appetite may have stumbled towards the end of the past week; but looking at the bigger picture, the market’s have neither backed off direction nor pace on the impressive, seven-month bull trend. Speculative interests are still fully in control at this point; but the fuel to this drive is developing a better fundamental foundation. Yield expectations are improving (and have found a big boost from the RBA specifically) and economic data is showing a clear movement towards global expansion.

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Risk appetite may have stumbled towards the end of the past week; but looking at the bigger picture, the market’s have neither backed off direction nor pace on the impressive, seven-month bull trend. Speculative interests are still fully in control at this point; but the fuel to this drive is developing a better fundamental foundation. Yield expectations are improving (and have found a big boost from the RBA specifically) and economic data is showing a clear movement towards global expansion. However, the balance between tangible and perceived strength is still heavily weighted towards the speculative, which means the risk of a volatile reversal in the markets in the coming weeks is still disturbingly high. That may not be the immediate concern of the average trader. However, even if fundamentals were left out of the equation, it is becoming more and more difficult to argue that the markets are not reaching extremes and are overdue for a meaningful correction. Taking measure of performance, the Dow Jones Industrial Average is currently up 54.5 percent in the span of only seven months. For comparison, it took four years for the benchmark equity index to climb that far in the period preceding the financial crisis – and that under far more robust conditions for growth and expected returns. In other markets, Gold is climbing to a record high and crude oil is up a staggering 143 percent from it slows. The currency market finds its representation from the battered dollar. Donned with title of top funding currency, the currency has depreciated nearly 16 percent on a trade-weighted basis and is already pushing 14-month lows with an open field to extend its push to recent record lows.

If there were ever a time to be skeptical of a strong, bullish rally; now would be that time. Not only have the risk-sensitive asset classes seen sharp moves in favor of optimism in just seven months; but they have done so without genuine fundamental support. Speculative interests were certainly capable of driving a significant reversal following the worst of the financial crisis. The markets were so fully drained of capital during the height of the seizure, that the return of wealth from the sidelines (and all at once) would easily leverage a substantial recovery from the disaster-level scenario that characterized the collapse following the Lehman Brothers’ collapse. However, there are limits to how much money there is on the sidelines; and (for our immediate purposes) there is a threshold for how quickly those funds will flow back into the speculative space. The most readily available capital and those speculators that are most tolerant of risk have already found their way back into the yield bearing securities. Most of what is left is large pools of money that requires a significant yield income (not capital gains) that can balance risk. With a heavy trader (as opposed to investor) presence, the threat of volatility is high. One of the greatest dangers to a market reversal is a building wave of profit taking. Those that have enjoyed capital gains through the past seven months will look to book some of that profit at some point; and with little hope of dividends or sizable coupon payments in the near-future, there is only one logical way to do so. Depending on how long optimism can hold up, we can see fundamentals slowly playing catch up. The RBA hike rates and indicated a relatively healthy pace of tightening to come; but the consensus is for the rest of the globe to wait until the middle of next year to move.

Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum

      DailyFX Carry Trade Index

Definitions:

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.

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 visa 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 middle of 2010. 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.

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.

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.
Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.