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Dynamic Carry Basket

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Finance Ministers And Central Bankers Are Running Out Of Time To Revive Growth And Sentiment

Mon, Mar 16 2009, 06:12 GMT
by John Kicklighter

DailyFX

How long do policy officials have to revive economic growth and stabilize the financial markets? How much worse can conditions become if the global leaders cannot come to a significant, joint policy response to the world’s ills?

• Finance Ministers And Central Bankers Are Running Out Of Time To Revive Growth And Sentiment

• Switzerland Adds Currency Intervention To The List Of Desperate Steps Policy Makers Are Willing To Take

• If GE Loses Its Top Credit Rating, It Won’t Be Long Before Unstable Economies Meet The Same Fate

How long do policy officials have to revive economic growth and stabilize the financial markets? How much worse can conditions become if the global leaders cannot come to a significant, joint policy response to the world’s ills? These are the questions the market is grappling with now; and ‘just how bad can things really become’ may be a question traders have to seriously consider over the coming weeks and months. While the fundamental outlook for general risk trends is not encouraging, carry interest received a significant boost this past week. The Index jumped over 650 points since last Friday, marking a notable break above resistance in the pressure-ridden, falling wedge formation that had taken responsibility for the steady downtrend in carry interest (and thereby sentiment) since the October panic. However, this break is hardly confirmation of a rebound in optimism. The breech relieves the stress on the market to force a major trend; yet the index is still entrapped within long-term congestion.
Such sentiment is reflected in the market’s more risk-sensitive asset classes. The Dow has recovered from a 12-year low, Treasuries have pulled back from record highs and the safe-haven US dollar has eased of its own three-year highs. Furthermore, some condition indicators have shown significant improvement: currency market volatility has certainly stabilized; risk reversals show are returning to neutral levels; and yields are starting to return.

It is easy to be comforted by the recovery of such notable indicators and markets; but the broader trends must be taken into account. A week’s rebound in equities and pull back in the US dollar mean little when they are still set within major trends and only arms distance from their respective extremes. Realistically, these are cautionary improvements as the market awaits clear fundamental shifts that signal a tangible recovery in economic activity as well as lender and investor confidence. Over the past few weeks, there have been signs of both improvement and deterioration. Quantitative easing, sizable stimulus packages, government guarantees and efforts to boost reflect a broad array of policy aimed at curbing the worst recession since WWII.
However, these efforts have not been universal. Whereas the US and UK have acted quickly and aggressively to their swelling problems; both Japan and the Euro Zone have lagged with their own responses. Without a unified response to this global problem, there is little doubt that conditions will worsen. Recently, the Asian Development Bank has suggested lost asset value could top $50 billion and the World Bank has projected the first global contraction since the 1930’s. Momentum behind this recession is being fed by the slump in investment and consumer spending, which itself is largely based on sentiment. With production and consumption slowing, major corporate bankruptcies becoming more frequent and now whole economies on the verge of default, drastic measures must be taken to prevent what could become a global depression.

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:

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 AUDUSD as global interest rates have quickly fallen towards zero and the lines between safe haven and yield provided has become blurred. Australia has a historically high and responsive benchmark, making it more sensitive to current market conditions. When Risk Reversals grow more extreme to the downside, 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.

Published on  Mon, Mar 16 2009, 06:19 GMT