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Dynamic Carry Basket

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Carry Interest Settles As Risk Aversion Consolidates Into Year End

Mon, Dec 22 2008, 06:04 GMT
by John Kicklighter

DailyFX

Year end is fast approaching; and seasonal factors are already having a clear impact on the liquidity underlying currencies and other markets. Thinned out markets may result in stalled trends and reduced liquidity; but it certainly does not mean that investor and lender confidence is improving.

• Carry Interest Settles As Risk Aversion Consolidates Into Year End

• Will Investors Turn Back To Carry In The Near Future?

• The Dollar And Yen Compete For The Title Of Top Funding Currency

Year end is fast approaching; and seasonal factors are already having a clear impact on the liquidity underlying currencies and other markets. Thinned out markets may result in stalled trends and reduced liquidity; but it certainly does not mean that investor and lender confidence is improving. In fact, over the past few weeks, risk sentiment has arguably grown more optimistic; and the carry trade is reflecting the fading forecasts. The DailyFX Carry Index has pulled back over 150 points through the week to 20,527. A look at the recent fluctuations in this composite shows clear congestion after the incredible momentum through October. From a practical standpoint, this is partly a reflection of investor sentiment stabilizing (though the inability of the index to actually gain ground suggests forecasts for volatility and returns continue to deteriorate) as well as position squaring with capital flowing towards safe havens until the market returns to full capacity. When volumes pick back up after the new year, they will see carry (risk appetite) hovering near six-year lows, volatility pushing record highs and interest rates offering potential returns at levels that truly reflect a global recession.

Fundamentally, the end of the year is draining the market of liquidity as holidays and accounting considerations lead investors to square their positions and prepare for a new year of trading. This will likely support congestion as there is not enough of a market to sustain momentum; though volatility may actually remain exceptionally high. Looking ahead, when it is back to business as usual, investors will not come back to healthy markets. Uncertainty has actually grown over the past weeks thanks to growing risks to credit and plunging forecasts for the broad economic recession. For growth, most of the third quarter GDP numbers are in; and the pace has been set well below policy makers expectations. Far more concerning is the more timely, monthly data which is suggesting the contraction is actually accelerating – a forecast that is shared by many who expect the first quarter of 2009 to mark the worst of the economic cycle. Far more fragile is confidence behind lending and investing. This Friday, the US government deferred the potential collapse of the entire US auto industry by extending a $17.4 billion rescue package to GM and Chrysler. However, this is not a permanent solution for this sector, and other companies and industries from around the world are on the verge. In fact, brining the market’s attention back to the battered financial group, the Standard & Poor’s Rating Services actually downgraded the credit ratings of 12 major banks. On the other side of the equation, potential returns continue to shrink with the Fed and BoJ cutting rates to 0.25% and 0.10% respectively.

Is Carry Trade a Buy or a Sell? Join the DailyFX Analysts in discussing the viability of the Carry Trade strategy in the DailyFX Forum

Risk Indicators:

Definitions :

What is the DailyFX Volatility Index:

TheDailyFX Volatility Index measures the general level of volatility inthe currency market. The index is a composite of the implied volatilityin options underlying a basket of currencies. Our basket is equallyweighed and composed of some of the most liquid currency pairs in theForeign exchange market. 

Inreading this graph, whenever the DailyFX Volatility Index rises, itsuggests traders expect the currency market to be more active in thecoming days and weeks. Since carry trades underperform when volatilityis high (due to the threat of capital losses that may overwhelm carryincome), a rise in volatility is unfavorable for the strategy.

What are Risk Reversals: