The Climb in Risk Appetite and Carry Interest Still Exposed to China, Europe and Speculative Runs

• The Climb in Risk Appetite and Carry Interest Still Exposed to China, Europe and Speculative Runs
• Friday’s NFP Release Can Certainly Influence Short-Term Volatility but What About Long-Term Risk Trends?
• Confidence in Rising Asset Prices is Undermined by Growing Risk Premiums

Most of the market’s favorite investor sentiment barometers are putting forth strong readings of optimism. Whether we look to the S&P 500, the safe haven US dollar or commodity-favorite crude; the reading is the same. However, the high correlation between these various asset classes (while itself is a strong tool for measuring conviction) can also distort the outlook for risk appetite trends. Equities, commodities and currencies are all heavily traded by speculators which in turn exposes them to the manias and panics (minor and massive) that often sweep over market participants. It is not easy to determine whether a rally or tumble in sentiment is overextended – indeed if it were, there would be far many more millionaires. That being said, one of the most basic means for establishing whether a market is over or under valued is comparing price action to the fundamentals that should stand as the foundation to the move. When expectations for growth, yield or capital flows deviates from the bearing of the markets, the likelihood that price or economic trends will correct to meet the other will intensify. And, the greater the time and/or intensity of the divergence, the more probable and dramatic the resulting adjustment is likely to be.

Assessing the situation now, there should be little doubt that fundamental promise and speculative trends are on separate courses. Looking across the standard bearers of risk appetite, the tinge of optimism is unmistakable. From the equities market, the S&P 500 has topped 1,120 while the Dow Jones Industrial Average has cleared a notable resistance level in 10,600. US crude’s rally above $80 was considered a defining trend development for the commodity market. Then there is the three-month low from the US dollar and subsequent highs from growth-dependent and high-yield currencies. There is little doubt, when looking at this mix, that there is conviction to the market’s capital flows. But, conviction in what? When we take stock of the economic and financial developments that have transpired during the weeks and months of speculative build up, it should be clear that the promise of capital gains (buy low / sell high and sell high / buy back low) is more prominent than an actual yield or rate of return. In fact, the general pace and performance of scheduled and unscheduled event risk this past week should give rise to concern rather than feed confidence. From what we have seen, the outlook for growth, the promise of higher yield and the stability of stable financial markets have all deteriorated.

Among the top fundamental concerns to develop over the past week, we have developments that should cover the full gamut for speculation. Substantiating officials’ and analysts’ warnings that economic output is cooling, the US (the world’s largest engine of growth) cooled more quickly than expected. To remind us that this is not a unique development, next week will bring the Euro Zone’s equivalent along with updates from the core members. Another role that the forthcoming European output numbers could play is a reminder of how exposed its markets are to shocks. There have been few splashy headlines of imminent collapse surrounding Greece or other EU members following the Stress Test results released last week. However, these same nations that are exacting extreme austerity measures on the local populace are also exposed to the global downturn in activity. If slowdown morphs into recession, credit could all but disappear and the region may find its private and public finances on the verge of disaster. Another, burgeoning threat to keep track of is China. It was recently leaked that the nation’s banking regulator told lenders to increase their stress test scenarios to a 60 percent loss in residential home values. That is a clear ingredient of crisis.

Risk Indicators:	Definitions:
DailyFX Volatility Index	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	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 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.
Reserve Bank of Australia Expectations	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:

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, Currency Strategist for DailyFX.com

To receive John’s reports via email or to submit Questions or Comments about an article; email jkicklighter@dailyfx.