Risk appetite has advanced for yet another week and in the process we have seen new highs set by EURUSD and the Dow Jones Industrial Average. However, with the G-20 meeting underway, we are in the midst of a very important transition. Though we are still a long way from a complete withdrawal, the world’s governments are already removing their financial support from the market.
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• Who is Leading and Lagging in the Global Economic and Financial Recovery?
• Will Interest Rate Prospects Pick up the Slack Should Capital Appreciation Slacken
Risk appetite has advanced for yet another week and in the process we have seen new highs set by EURUSD and the Dow Jones Industrial Average. However, with the G-20 meeting underway, we are in the midst of a very important transition. Though we are still a long way from a complete withdrawal, the world’s governments are already removing their financial support from the market. This is a critical and risky step in returning to the conditions that were ‘normal’ prior to the worst onset of the worst financial crisis since the Great Depression. Now, we will see whether risk appetite is in fact recovering or if the temporary guarantees and liquidity buffers provided a false sense of security that will come crashing down. Taking a snap shot of current market levels, optimism is still firmly planted. For the currency market, carry interest has risen to highs not seen the capital markets were in the middle of the sharpest free fall in modern history (October 10th). The building interest in carry is finding consistent support from rising yields and tempered risk. While there is a considerable possibility of a temporary market correction (or trend change), the fear of another systemic seizure has vanished. Naturally, corporate default premiums are less than a third of what they were during the height of last year’s panic and the demands for return on speculative assets over risk free is at its lowest since before the Lehman Brothers’ collapse. At the same time, diminished risk means little without the potential for income. Benchmark rates are still extraordinarily low; and yields on speculative assets will be tempered until the foundation is lifted. Yet, in the meantime, there are sources for income – like funding carry positions with dollars.
The US dollar has quickly become one of the most popular currencies in carry trade circles – though not for its positive attributes. In recent weeks, the benchmark market rate (the three-month Libor) for the US has consistently edged to new record lows. This is not unusual as yields on similar products in other financial centers around the world has done the same. What is notable though is the fact that the US rate is now at a discount to nearly every one of them – including its Swiss and Japanese counterparts. This positions the dollar as the world’s most attractive funding currency all while carry interest is building momentum. For now, this provides unique opportunities for stable pairs like EURUSD and AUDUSD; but can these conditions last? Certainly, the dollar’s role as a funding currency will not likely last for long. While rates are low now and Fed Chairman Bernanke has vowed to keep them that way well-into 2010; the draw of American assets and its deep markets will eventually draw lending rates higher and fortify the currency. But, the more important consideration is how will risk appetite as a whole perform going forward. In the next few months, there will be a major test in the conviction of investors’ optimism as governments start to implement exit strategies for the trillions of dollars of support that is still propping up the markets. Many of the industrialized powers have already started the process. Just today, the Fed announced it was further reducing some of its emergency lending programs (TAF and TSLF); and the German Federal Finance Agency cuts its proposed debt lending through the end of the year. These changes are generally ignored; but they represent serious progress towards a true withdrawal. Should the G-20 offer a coordinated time frame, it would make the transition more of a reality for the all involved.
| 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 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. |
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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 [email protected].
