Currencies | Jun 27 2011
QE2 Expiring, Greece Crisis Deeping – Perfect Storm For Dollar, Risk
By John Kicklighter, Currency Strategist
– QE2 Expiring, Greece Crisis Deeping –Perfect Storm for Dollar, Risk
– Liquidity Demand Swelling as Speculative Returns Falling Back
– S&P 500, Gold, Oil, Treasuries and the Dollar All Position For Reversals
The FX market’s most liquid pair (EURUSD) and carry trade itself are on the verge of significant, bearish reversals. However, that is not the full extent of the tension. If we broaden our scope to include equities, commodities, Treasury and money markets; we see the same general patterns. After long-running rallies and a subsequent period of congestion, all of these prominent asset classes are threatening trend-defining reversals. What makes this particularly interesting though is that they are all lining up to the same fundamental conclusion: the shift of capital from the high-yielding and high-risk assets to the deeply liquid safe havens. And, it just so happens, that a series of fundamental fronts are coming together to threaten the perfect market event to prompt trigger just such a elemental change.
Looking across the markets, we should account for the pressure on the various benchmarks and the fundamental correlation their respective strain reflects. At the forefront are the favored speculative assets. The S&P 500 has broken a bull trend that has guided the index to three-year highs since September. The critical step, though, will come when 1,250 gives way and the advance from the March 2009 ‘V’-shaped reversal following the worst financial crisis in modern history is finally broken. US Oil is facing a similar crossroad around $90-per-barrel. Things are a little more complicated when it comes to the bonds and rates market. The reflection of an active US-government bid, the 10-year Treasury is starting to waver after a multi-month run; while the three-month US Libor rate is slowing its descent to fresh record lows. Marking the absolute foundation of the global financial markets, we are starting to see disturbing rumblings in overnight cash markets. Short-term cash spread have shown significant jumps in US, European and Asian markets. Looking back, the freeze of funds at this level turned a market slump into a full blown crisis back in late 2008.
Developments that have ushered the market to this ledge have been long incubating; but until recently, the collective speculative ranks have been able to downgrade the risks to focus on returns. The unquestionable support of the world’s governments has created an unmistakable brand of moral hazard and exceptionally low lending rates – factors that are so substantial that otherwise anemic rates of return have offset a fundamental risk like a building European financial crisis. The situation with Greece is perhaps the most easily identifiable; but it hardly stops there. We have already seen the funding and ratings troubles hit Portugal, Ireland, Spain and now Italy. Outside of Europe, we have a cash crunch developing in China following its effort to curb excessive lending, the fallout of UK austerity, a Japanese economy that is struggling to balance finances with growth and the US planning to let its stimulus build up expire.
The end of QE2 is perhaps the most important change the global markets face. The US government’s and Fed’s effort to pump capital into its economy and market has indirectly propped up global speculation. Much of the capital that was destined for US businesses and consumers made its way to emerging markets and other countries’ endeavors. When this cheap funding is withdrawn, the leverage for sentiment and yield will be taken away. Moving forward, the Fed will likely hold its balance sheet stable for some months before embarking on a drawdown. That said, speculation of this change and a swell in the risk side of the ledger will put things into motion.
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 vice versa.
We use risk reversals on USDJPY as global interest are bottoming after having fallen substantially over the past year or more. Both the US and Japanese benchmark lending rates are near zero and expected to remain there until at least the end of 2011. This attributes level of stability to this pairs options that better allows it to follow investment trends. When Risk Reversals move to a negative extreme, it typically reflects a demand for safety of funds – an unfavorable condition for carry.
Reserve Bank of Australia 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 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.
Highest And Lowest Yields:
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.
The views expressed are not FNArena's (see our disclaimer).
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Technical limitations
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
