Is it a coincidence that the bullish rally behind the capital markets has stalled and threatened a retracement just as the world’s central banks start to confirm their intentions to withdrawal the emergency aid initially put into place to stem a financial  and economic collapse? While it is too early to tell whether the removal of speculators’ government safety net will spark profit taking and a meaningful reversal from those proxies that have risen so consistently through most of the year; we are seeing market participant growing more critical of the divergence between the fundamentals and the months of speculative exuberance.

•    Risk Appetite, the Dollar and the Dow Await a Fundamental Catalyst to Establish the Next Principal Trend
•    The Correction in Market Benchmarks Reflects a Tempering of Sentiment
•    Forecasted Returns are Dampened by the RBA’s Toned Down Interest Rate Forecast

Is it a coincidence that the bullish rally behind the capital markets has stalled and threatened a retracement just as the world’s central banks start to confirm their intentions to withdrawal the emergency aid initially put into place to stem a financial  and economic collapse? While it is too early to tell whether the removal of speculators’ government safety net will spark profit taking and a meaningful reversal from those proxies that have risen so consistently through most of the year; we are seeing market participant growing more critical of the divergence between the fundamentals and the months of speculative exuberance. However, despite this backdrop, it is imperative to remember that risk appetite is its own catalyst; and optimism based solely on distant economic forecasts and the promise of capital returns has proven itself immune (or temporarily blinded) in the past. It is clear from the popular proxies for underlying sentiment that we are at another critical point in the seven-month bull wave where the scales can be tipped either way. The Dow Jones Industrial Average (our proxy for the speculator-friendly equity market) finally found direction in its chop this week to push back above 10,000. The more meaningful milestone would be surpassing the 13-month, range high of 10,120. For the US Dollar, the failure to surmount resistance derived from the five month falling trend channel (on the trade-weighted index) similarly speaks to a narrow miss of a significant reversal in risk appetite. A look at volatility indicators suggests market participants believe we have avoided a reversal. The CBOE VIX and DailyFX Currency Volatility Index have both retraced sharply from four-month highs.

Despite the pressure building behind market congestion and the considerable activity in volatility indexes (an indirect gauge of insurance premiums for dramatic price action), the fundamentals have changed relatively little over the past weeks and months. The outlook for economic activity and rates of return are still as tepid as before. What has changed is speculation. Economic data and official projections offer a view on where growth, interest rates and lending may be in the future; but the outlook for the markets is always filtered through investors’ eyes. Until recently, the rough outlook for a return to global expansion and the promise that bloated stores of sidelined capital would have to find its way into the speculative market was all traders needed to believe they would be able to buy low and sell high. However, long-term funds have not been a major participant in this year’s market recovery (at least not in comparison to their presence before the crisis started to play out). These pools of capital look to collect yields, dividends and other regular income; and in turn, they are relatively tolerant of moderate capital losses. Yet, benchmark market rates (like the 3 month Libor) are still hovering near record lows and buying in now would be expensive indeed considering there is no yield income. For the traders already in the market and those on the sidelines, the seemingly coordinated effort by central banks to withdrawal financial support means policy officials are more optimistic on stability and growth but it also means there is less of a backstop and cheap cash. These are still early stages in the exit plan though. Gauging the balance of risk and return though, the RBA (the market’s high-yield leader) decided to tone down its own pace of rate hikes. No one can fully avoid the strained recovery of the world’s largest economies.


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.