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Risk Appetite Pulls Back Once Again but When Will the Bull Trend behind Currencies and Equities Finally Break?

Summary: Risk appetite has turned into another tentative reversal. These brief periods of tempered sentiment set within a more consistent and heady rise in optimism...

Risk appetite has turned into another tentative reversal. These brief periods of tempered sentiment set within a more consistent and heady rise in optimism has been the normal pace the since the middle of July. So, the question we have to ask ourselves is whether the pull back over the past week is just another instance where the market is catching its breath before forging ahead or the makings of a meaningful and certain turn in risk appetite. • The IMF Lifts its Forecast for Growth but Warns of Greater Financial Losses Ahead • How Long will the US Dollar Keep its Funding Currency Status with Rates at Record Lows and Reserves Shifting? Risk appetite has turned into another tentative reversal. These brief periods of tempered sentiment set within a more consistent and heady rise in optimism has been the normal pace the since the middle of July. So, the question we have to ask ourselves is whether the pull back over the past week is just another instance where the market is catching its breath before forging ahead or the makings of a meaningful and certain turn in risk appetite. The fundamentals that have developed over the months have increasingly supported an approach of caution as the outlook for growth has been deemed feeble and the prognosis for competitive yields in turn rendered bleak. Nonetheless, speculation doesn't have to follow the lines of rationality and the natural stream of capital from the financial sidelines can continually feed the draw of capital gains. The appeal of buying into trends that are still young and selling later down the line clearly has its appeal for those that are looking to get back into the market and/or lost a significant percentage of their wealth during the 2007-2009 financial crisis. This is perhaps the most accurate rational for the steady trends the currency, equity and other capital markets that have sported since the definable turn in risk appetite back in February/March. However, this trend will not last forever; and the current pull back is putting the bull phase's stability to the test once again. In the past week, we have seen both the dollar and yen make sharp but measured gains against high yielders. For confirmation, the Dow is the midst of its of its deepest correction since early July. Seeing a moderation in sentiment now seems unusual considering the tangible, bullish developments we have seen data, commentary and commentary over recent days and weeks. The most promising piece of news came just today with the IMF's World Economic Outlook report in which they upgraded their growth forecasts from April. From earlier projections of a 1.4 percent contraction in the global economy this year and 2.5 percent expansion next year; they now see a 1.1 percent pace of decline in 2009 and 3.1 percent growth in 2010. However, given the timely economic data that has been disseminated and development in policy makers comments since the last IMF assessment, it is safe to say that this improved outlook has already been priced in. Instead, what may not be fully accounted for in a market that has maintained a steady and aggressive recovery was the notes from their Global Financial Stability Report in which the bank said the world has only seen half of the losses that are expected to be accumulated before the full effects of the worst financial crisis since the Great Depression have passed. Echoing these concerns the US Shared National Credit Review (which the Federal Reserve and FDIC contribute to) said credit quality in 2009 is at a record low and total bank losses have so far reached $53.3 billion - nearly three times the previous peak in 2002. This places the disparity between the outlook for financial markets and their current heights in deep relief. While there is no doubt a recovery is taking place; it is a natural rebound from a recession rather than the makings of a strong bull market. When government stimulus is rolled back, we may very well see another economic slump. 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 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 middle of 2010. 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. 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. Written by: John Kicklighter, Currency Strategist for DailyFX.com. Questions? Comments? You can send them to John at jkicklighter@dailyfx.com.

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Publication:Mena Report
Geographic Code:1USA
Date:Oct 2, 2009
Words:1484
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