The DailyFX Carry Trade Index was practically unmoved from last week after heavy event risk failed to generate direction for the yield strategy. In fact, carry interest has actually worked its way into a period of congestion that has sapped all of the momentum out of the developing rebound after the March reversal. This indecision likely comes from the clouded outlook for global interest rates with deteriorating growth trends making its difficult for policy makers to focus on the greatest inflation pressures in a generation. Certainly this uncertainty was reflected not only in price action, but market conditions as well. Volatility in the currency market jumped back firmly back above the 10 percent mark; and USDJPY risk reversals have experienced a sharp jump in the demand for protective puts.
• Will A Restored Correlation Between Carry And Equities Pull The Yield Strategy Down? • Forecasts For Ongoing Write Downs, Liquidity Concerns And Recessions Still Evident
Looking at the fundamental influences behind the carry trades lack of direction, there may be more at work than merely concern over the sustainability of wide yield differentials. Instead, recent data and dour forecasts from policy officials and analysts suggests financial markets may be heading for another crisis that rivals what followed the subprime market collapse last year. First of all, the equity markets have tumbled and the carry trade has yet to catch up. In recent history, the overwhelming influences of risk trends over the market have led the carry trade pairs and equities to move more or less in lock step. However over the past few months, the two have diverged with USDJPY climbing to four-month highs, while the Dow pushes to lows not seen since August of 2006. The correlation may return however, if forecasts for worsening credit conditions are realized. Moody’s has forecasted a five fold increase in defaults over the coming year, while a recent credit report from the BoE clearly states UK lending will worsen in the coming three months. Ultimately, with banks still starving for liquidity and writedowns expected to continue, it seems like the dominos are much bigger this time around.
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Carry Basket Component Currencies:
Risk Indicators:
Definitions:
What is the DailyFX Volatility Index (VIX):
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 (as implied volatility for puts is quoted as a negative percentage and implied volatility for calls is quoted as a positive percentage) 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 Analyst for DailyFX.com Questions? Comments? You can email them to John at jkicklighter@daily.com.