Carry Rebounds On Improved Risk Appetite And Volatility, But Will The Calm Last?

• Carry Rebounds On Improved Risk Appetite And Volatility, But Will The Calm Last?
• Investor And Lending Panic Abates, Yet Credit Collapse And Recession Far From Spent
• Are These The Right Conditions To Return To A Lower Yield, Higher Risk Carry Strategy?

Though price action settled into the weekend, traders shouldn’t be lulled into thinking that fear has been exercised and risk appetite will lead to an immediate turn in the carry trade. With credit markets still working off excess leverage and diminishing interest rates reducing returns, the outlook for carry and all other high-risk strategies is still bleak. If we were judging conditions by the past week alone, it may indeed seem as if risk appetite had turned. The DailyFX Carry Trade Index surged 825 points to 23,133. This was the first improvement in four weeks and helped to take some of the pressure of the last week’s sharp decline – the biggest in at least 15 years. What’s more, volatility (one of the best gauges of fear for any market) dropped an incredible 3.3 percent. However, when we look at the bigger picture, we can see that these were relatively modest improvements in a broader collapse in risk appetite. While the carry index experience a significant recover, it remains just off of five-year lows. What’s more, volatility of 15.8 percent in the currency market is nearly three times the level of expected activity back in the first half of 2007 – when the carry trade was still near its peak.

It may be tempting to call the bottom in the carry unwind; but the critical fundamental questions that have to be asked to qualify such speculation do not support the recovery of a strategy that requires low volatility and abundant return. To begin with, risk is still lingering in the market. Not only is volatility high for currencies, it is high for equities, commodities and many other asset classes. Indeed, it will take considerable time before caution gives way to unencumbered speculation considering the crash markets suffered so far this month. What’s more, the source of the worst rout since the Great Depression is still hanging over lending and investment trends: credit. Though the governments of the world’s largest economies conducted coordinated rate cuts, guaranteed lending and put up massive amounts of money to draw the toxic debt out of the market, this cumulative effort means little to a $55 trillion credit derivatives market. With banks, investors and lenders still extremely overleveraged through credit, the markets can easily overwhelm rescue efforts. What’s more, even if credit were not an issue, the fact that the global economy is heading into a recession and rates are dropping would be.

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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 visa versa.

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.

Bank of Japan Rate 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 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.

To read this chart, any positive number represents an expected firming in the Japanese 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 contract and carry trades will suffer.

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.