How promising is the outlook for growth and expected returns? This is a critical question that has perhaps been glossed over, or in some instances utterly ignored, over the past six months. However, now that the world’s economy seems to be hitting its stride in the burgeoning recovery; investors are seeing the tempo that the markets can be expected to run more clearly. And, after eight months of solid rally for even the most suspect of assets, it seems investors are ready to take a hard look at current values and measure them up to where conditions will be three, six, twelve months down the road.

•    Reality Setting in as Growth, Interest Rate Forecasts Stall Carry and Stock Rallies
•    Are the Global Financial Markets Heading into Another Asset Bubble?
•    The Lines of Funding Currency and Carry Currency Begin to Blur as Speculation Levels Off

How promising is the outlook for growth and expected returns? This is a critical question that has perhaps been glossed over, or in some instances utterly ignored, over the past six months. However, now that the world’s economy seems to be hitting its stride in the burgeoning recovery; investors are seeing the tempo that the markets can be expected to run more clearly. And, after eight months of solid rally for even the most suspect of assets, it seems investors are ready to take a hard look at current values and measure them up to where conditions will be three, six, twelve months down the road. We can already see a sense of hesitation across the major asset classes. The Carry Trade and US dollar are ideal gauges of risk appetite for currencies – if not the financial markets as a whole. The carry trade index has carved out another swing high, but the peak for November is notably lower than the 14-month high set back in October. Forced into a position of greater fundamental sensitive to underlying sentiment, the US dollar could signal a reversal (or revival) of capital market’s bull trend far earlier than the less responsive carry basket. On a trade-weighted basis, the US dollar is hovering just off 15-month lows; but the foundation for its bearish trend is just as close and a reversal can easily feed an oversold scenario. The same general conditions can be applied to stocks and commodities like gold. While the Dow has edge higher these past few weeks, volume has grown progressively weaker – denoting a lack of conviction. Gold is perhaps the most onerous of the speculative assets. Considered a high-return vehicle, inflation hedge and safe haven alternative; this commodity is just as prone to a correction in sentiment as any other security while inflation is certainly far off and volatility of this level offers little stability.

From the fundamental side of things, the argument for moderation and caution continue to grow. While the Organization of Economic Cooperation and Development (OECD) upgraded its growth forecasts for 2010 recently, the resultant outlook does not reflect the boom years of bygone years; rather, it reflects uneven and fragile expansion that is still heavily backed by government stimulus. The removal of this ‘safety net’ is a necessity to working down record deficits and encouraging stability as well as long-term growth. However, it is also the backstop to any financial crises that  may develop going forward and the primary source of cheap lending. Both of these conditions are integral to feeding optimism. Policy official around the world have already voiced their concern over the side effects of nearly unlimited levels of cheap cash. The chorus out of China for an quickly building asset bubble has shown what can happen at the extremes of the current policy stance. In fact, a range of Asian economies have voiced their concern that the Federal Reserve’s policy of keeping its benchmark lending rate at its extreme low is actually feeding the building problem. San Francisco Fed President Yellen addressed this concern in a recent speech; but she said it was not clear whether the central bank should focus on global concerns like this when determining policy. Realistically, the problem lies not with the policy authority’s policy but in the market situation that it exists in. Policy makers have warned for months that truly promoting stability means correcting large imbalances in the global economy. Among the largest inequities are the dollar’s use as a reserve; the yuan’s managed exchange rate; and the abundance of leverage.

Is Carry Trade and risk appetite rising or falling? Discuss the market sentiment and how to trade it in the DailyFX Forum

Risk Indicators:	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.