Despite a sharp increase in credit market concerns surrounding the health of Freddie Mac and Fannie Mae, as well as caution heading into the thick of the second quarter earnings season, carry interest actually rose over the past week. The DailyFX Carry Trade Index rose 124 points from last week to 29,059. However, further upside progress has clearly be curbed by a triple top that has dampened risk appetite since May.
• A Carry Breakout A Matter Of Time As Earnings And Credit Crowds Headlines
• Volatility And Put Interest Has Jumped To Multi-Month Highs
• If Freddie And Fannie Are Secured And Earnings Strong, Can Carry See An Upside Break?
Despite a sharp increase in credit market concerns surrounding the health of Freddie Mac and Fannie Mae, as well as caution heading into the thick of the second quarter earnings season, carry interest actually rose over the past week. The DailyFX Carry Trade Index rose 124 points from last week to 29,059. However, further upside progress has clearly be curbed by a triple top that has dampened risk appetite since May. Whether or not demand for return and the carry trade index itself can finally push through resistance will likely depend on the resolution to the US policy officials handling of their insolvent GSEs and the size of the largest investment banks’ write downs. In the meantime, fear is certainly tangible in the market condition indicators. The DailyFX Volatility Index (a good gauge of fear) saw its sharpest jump since March with a 0.77 percentage point increase to 10.79 percent. This concern over a possible breakout happened to accompany a sharp increase in put buying, suggesting traders already have one foot out the exit just in case.
The DailyFX Carry Trade Index’s recent price action characterizes the market’s approach to risk relatively well. This past week, the debate over the health and solvency of Freddie Mac and Fannie Mae roiled the capital markets. However, assurances by policy officials that the firms are well capitalized has seemed to calm the storm somewhat. Nevertheless, suggestions that the government may buy unlimited shares of both, open the discount window for them or may take a more uncouth approach to bailing the country’s biggest lenders comes with problems of its own. The US government is flirting with nearly doubling its debt load in offering help and inadvertently encouraging overconfidence that their will always be a back up for banks taking unnecessary risk. The other major uncertainty surrounding the financial markets is the severity of second quarter earnings disappointments and write downs. So far, the damage has been limited with JP Morgan and Blackrock outperforming expectations. However, Merrill Lynch’s $9.7 billion write down and worst than expected net loss are certainly keeping investors on their toes.
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| Risk Indicators: | Definitions: |
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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:
We use risk reversals on USDJPY as it is the benchmark yen pair and the Japanese currency is considered the proxy funding currency for carry trader. When Risk Reversals grow more extreme to the downside, there is greater expectations for the yen to gain – an unfavorable condition for carry trades. |
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Forecasting rate decisions is notoriously speculative, yet the market is typically very efficient at predicting rate movements (and many economists and analysts even believe the market prices influences 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 Bank of Japan will make over the coming 12 months. We have chosen the Bank of Japan as the yen is considered the proxy funding currency for carry trades. |
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.
