FYI | Aug 23 2007
By Chris Shaw
Last week’s decision by the US Federal Reserve to lower its discount rate has restored a sense of relative calm to currency markets (and brought the bulls back to equity markets) but Danske Bank takes the view the more prudent course of action is not to rush back into carry trade positions.
In the bank’s view there are several reasons why a more conservative approach is the better idea, including that carry trade performance has simply returned to its long-term trend despite implied volatilities remaining very high.
Even with higher volatility at present the market remains net long of carry trade positions, yet in the bank’s view it is likely to take a couple of weeks to know whether the Fed’s move will actually be a success in terms of restoring order to markets.
The bank also suggests there is scope for Japanese investors, who have been leading the way in terms of implementing the carry trade, to be forced into margin calls or simply choose to cut their positions if they were caught on the wrong side of the yen’s gains over the past week, which would imply further upside to the Japanese currency.
Another possible source of market volatility will be upon the market in a few weeks as the bank points out August 15th was the final day for investors to advise of redemptions from hedge funds for the third quarter, meaning these funds may need to further liquidate positions to meet the requested levels of withdrawals.
Given this uncertainty the bank’s stance is it is still too early to either re-establish old positions or take out new ones in currency markets, especially as while the economic fundamentals during the first half of the year were supportive of the carry trade the market has now temporarily forgotten fundamentals and is pricing in a significant deterioration in the global economic outlook, something that may or may not eventuate.
The link to pricing based on fundamentals may and in all probability will return at some point in the future, but until it does the bank sees little benefit in acting according to fundamentals.
There is another reason for this stance, as Danske Bank views the Federal Reserve action as a liquidity measure rather than a policy change. In other words, the market expects the Federal Reserve to follow through with cuts to official interest rates (and as many as three cuts by the end of the year are being priced in according to current market expectations), but there is no guarantee this will actually happen.
Danske Bank’s view is the Federal Reserve may actually want more evidence of continued problems in markets before it cuts rates, otherwise it could have simply cut them last week.
If it happens that the expected rate cuts don’t eventuate the reaction of traders and hedge funds is likely to be similar to equity investors who sell off a stock when it falls short of earnings expectations.
This means there is a relatively high probability of further adjusting of positions, so according to Danske Bank the whole story has further to run.
