It has been said before the crisis the financial markets have been suffering for nearly 18 months now was one of confidence – or a lack thereof. That would imply that, though the outlook for the global economy is bleak, a rebound in investor sentiment could turn the market’s around. This is a forecast that, so far, is founded on price action rather than fundamentals.
• Has Market Confidence Been Restored By The G20 Policy Sweep?
• Risk Still Inherent As Deleveraging And Recession Remain
• When Will Interest Rates Factor Into The Recovery Of Carry?
It has been said before the crisis the financial markets have been suffering for nearly 18 months now was one of confidence – or a lack thereof. That would imply that, though the outlook for the global economy is bleak, a rebound in investor sentiment could turn the market’s around. This is a forecast that, so far, is founded on price action rather than fundamentals. Looking across the markets, there have been tentative rebounds in risk appetite measured through equity indices, corporate bonds and the currency market. For the FX world, strength in the Australian dollar, New Zealand dollar and yen crosses has encouraged a sustained advance in the Carry Trade Index. This past week, the barometer for risk appetite rose another 393 points to 22,560 – the indicator’s highest level since early November. It is hard to ignore the strength the index has maintained over the past weeks to lift carry interest over 16 percent from the six year low set back in February. What’s more, others readings for risk appetite in the currency market have shown similar progress. Volatility has extended its deflating trend as the frequency of dramatic market shocks diminish. The DailyFX composite Volatility Index is currently just below 17 percent – near its lowest level since before the October market crash. Speculative interest has also improved through options as risk reversals on the highly polarized AUDUSD pair are the closest to zero that they have been in over a year. The only real hitch in this uniform recovery from indicators is the lack of an interest rate outlook – and therein lies our skepticism.
To support a genuine recovery in risk appetite and speculative interest, the potential for returns must at least compensate for the risk of loss. This is true of not only individual assets but for the market in general. Over the past months, as many of the more speculative markets have turned to consolidation, we have only seen the abnormally high level of risk moderate. This means that investors and traders are not in a panic state under the fear that liquidity could completely vanish and systemic failure is a real possibility. This, is an improvement, but not a genuine recovery in risk taking conditions. Looking at the other side of the market, the potential for returns is still historically and categorically lacking. Global interest rates are at the lowest levels that they have been in recent history and the momentum behind economic recession (whether there are forecasts for improvement later this year or into 2010) is fully expected to hold at least into the middle of this year. This means the foundation for investment returns will remain naturally depressed for some time (dampening potential capital gains and the demand for carry interest as yields differentials are too thin). This leads us to ask the question: does the G 20 truly encourage confidence? A critical review of the proposals sees plans that have opaque or no time tables for implantation and no clear lines of responsibility. The market may grow tired of aggressive stimulus proposals that aren’t executed.
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| Risk Indicators: | Definitions: |
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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. |
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What are Risk Reversals:
We use risk reversals on AUDUSD as global interest rates have quickly fallen towards zero and the lines between safe haven and yield provided has become blurred. Australia has a historically high and responsive benchmark, making it more sensitive to current market conditions. When Risk Reversals grow more extreme to the downside, it typically reflects a demand for safety of funds - an unfavorable condition for carry. |
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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. |
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.
